Should I Stay or Should I Go?

As well as being a hit song for the Clash, this is a dilemma that many employees may find themselves in when leaving an employer or retiring. If they are part of a company pension plan, they may have to make some very important decisions.

Two potential options, are leaving the pension with the employer or transferring the commuted value to a Locked-In Retirement Account (LIRA). Each pension plan is unique in their benefits and each employee has their own unique circumstances and situations to take into account. These are some of the factors that need to be considered before you make that decision that will have long term consequences.

In a pension plan, the plan administrator will make the investment decisions for the Defined Benefit Pension Plan. Their goals and risk tolerance may not align with yours. In a LIRA, the annuitant will have more involvement and choose from a much wider range of investments.

If you take the pension, initially you will have the full dollar value, though some company contributions may take 1 to 2 years to fully vest to you. In a LIRA, there may be a maximum Transfer Value that can be rolled to a LIRA. If you have available RRSP room, some can be transferred to a RRSP. The difference may have to be taken as cash and added to your taxable income. A cash payment from a commuted value may assist a person if they have any debt, such as a mortgage. Your personal circumstances are always a factor in your decision making.

The pension has limited flexibility once your payments have begun. Benefits are payable for life and no lump sum withdrawals are allowed. When converting a LIRA to a LIF, you have much more flexibility. You can start at any age between 55 and 71, though the annual income will be subject to minimum and maximum amounts. Pensions registered in Ontario, can be unlocked up to 50%. This can be transferred to a RRSP or even taken as cash, with its tax consequences.

If pension payments have started, if the owner passes away, the spouse usually receives a reduced amount payable monthly. The reduced amount payable to the surviving spouse can vary by plan, and in some plans, the payments are only for a limited period of time. There is no estate value once the surviving spouse passes away. In a LIF, the surviving spouse may receive 100% of the remaining value tax deferred. Once the surviving spouse passes away the remaining value is payable to any named beneficiary or the estate. The estate is responsible for paying taxes on this amount. A LIRA or LIF can also be unlocked and made accessible for financial hardship, shortened life expectancy, lesser amount or medical expenses.

A company pension is invested as the plan administrator chooses. Some administrators choose to invest in GICs. Lack of flexibility in their investment mandates may make it difficult to maintain funding objectives. The commuted value of a pension plan has an inverse relationship with interest rates. The commuted value, when paid out, represents the present value of what would be needed to pay a given stream of future payments. The lower the interest rates are, the larger the lump sum payment you will receive. We are presently at historically low interest rates, which will most likely not change soon.

In Ontario, the Pension Benefits Guarantee Fund protects up to $1,500 per month of your monthly pension payout. The difference could be lost if the employer has financial difficulty or employer bankruptcy. With a LIRA/LIF you can control the guarantees of your investment and diversify as you wish to ensure its continuity.

Other important factors to take into consideration when making your decision include the following. Surviving spouse benefits from a pension plan are usually only paid to the spouse at the date of retirement. A new spouse after retirement will not receive survivor benefits. Some pensions are not fully indexed to inflation. You will find your purchasing power quickly eroding as the years add up. If you have worked for a number of different companies, you can consolidate your LIRAs into one LIRA. Taking the commuted value may provide an opportunity for an inheritance to a non- spouse. Usually, only retirees who receive a pension qualify for medical and dental benefits after age 65.

Working with a trusted advisor, you can review the pros and cons of your specific options. Each pension plan is structured differently and should be analyzed for your unique situation to achieve your goals and objectives. Ensure you have a financial plan in place. This may reduce the temptation to deplete funds that have been set aside for retirement. Looking at your overall goals use the plan as an opportunity to create a financial future that achieves your objectives.

Written by George Comminos CFP CIM

Fundamental Analysis and Firm Value Maximization

When selecting an investment for a portfolio, the options available are vast, diverse, and seemingly endless. However, of all the available publicly traded companies on global equity indexes, narrowing down to a world class, value based, and diverse portfolio requires a strong discipline for screening out companies that do not fit your criteria. When examining equities, we prefer to use the strategy of fundamental analysis which examines potential candidates on the grounds of intrinsic value from a bottom-up approach. The primary goal of a firm is to maximize the value of the business and reflect this value maximization onto business owners. As such, one element of fundamental analysis concerns how well a firm achieves this goal, and we believe there are three broad categories that business operations fall under that help guide portfolio eligibility.

The first of which is the investment decisions of the firm. When undertaking business endeavours, the firm should examine the required hurdle rate and only invest in projects which have a positive net present value exceeding the hurdle rate. This rate is the required return based on the allocation of debt and equity used to fund the project, and the required return should also be a function of size and timing of cash flows and other monetary benefits to the firm that will be realized in the future.

The second category is the financing decision whereby a firm should seek out the optimal capital structure to fund projects and ongoing daily operations. Not only does the optimal capital structure feed into the investment decision we discussed earlier, but it also maximizes the current and terminal value of the firm. This is critical as it allows for continued growth and stability, but also benefits the equity price as it leaves as little room as possible for deadweight loss in valuations.

The third and final category of value maximization is the dividend decision. This decision is extremely important as it allows someone analyzing the firm to see how the business treats excess capital. If the firm is unable to find investments that exceed the hurdle rate, a decision must be made on how to best return capital to owners. The options on the table include:

(1) Sidelining cash for future projects that do meet the hurdle rate.
(2) Buying back equities if the firm believes the share price is undervalued.
(3) Distributing excess capital in the form of dividends.

When examining these categories, while they seem relatively simple and reasonable, there is a large portion of the equity market that disregards at least one of these fundamentals and any major flaws in the structure can be an indicator of future problems if the firm has not already acknowledged and outlined a plan to correct the course. As such, when conducting portfolio research, we seek out firms that actively work to meet the criteria in all three categories. In summary, when conducting a fundamental analysis, the steps in determining whether the firm is actively maximizing value is to ask whether they wisely invest funds in positive net present value projects, optimize their capital structure to properly finance activities, and finally how they treat excess capital (preserved, distributed, or squandered).

Fundamental analysis goes much deeper than this, but every successful portfolio requires a stable and disciplined framework, and the value maximization model is an excellent framework to utilize as it asks strict questions and works to deliver best in class equities to the portfolio when paired with deeper fundamental analysis.

Written by Adam Prittie, Investment Advisor

You and Taxation! Limited Partnerships and Avoiding Double Taxation

Limited Partnerships (LP) are unique in many ways. One such way is taxation. When investing in an LP within a non registered (cash) account, it is imperative that you track your cost base and factor in capital gains or other income generated by the manager. Otherwise, you will pay tax twice! Once when you file your T5013 tax slip for the income and again when you sell your shares/units down the road. This is known as double taxation and can easily be avoided by tracking and adding any T5013 income to your original purchase price.

For example, if you invested $100,000 in a LP and the fund realizes $5,000 in capital gains from trading by the manager, your annual T5013 tax slip will indicate this. You will pay tax on the net gain of $2,500 (5,000 x 50% inclusion rate) based on your marginal tax rate. Now in addition to the earnings, the value of the investments held by the fund increased by an equal value of say 5%, your statement would show the original investment worth If in this simple explanation, this repeated for five years, you have received a T5013 slips worth $25,000 (net taxable is $12,500) and tax paid at say 50% = 6,250. The LP is now valued at $125,000 at the end of five years. You have now found a nice retirement condo in Panama and you decide to sell your LP shares. What is the tax? Many will state the tax is $12,500 ($125,000 minus the purchase cost of $100,000 = a capital gain of $25,000/2 = $12,500 taxable and alas $6,250 payable). However, this is incorrect and if processed this way results in double taxation.

The actual adjusted cost base has risen to $125,000 because each year you (remember those T5013 slips?) tracked all your T5013 numbers and added them to your original purchase price. In my simple example, this adds up to $5,000 x 5 = $25,000 which you already paid tax on. If your adjusted cost base is $125,000 and the proceeds of sale are $125,000 then the tax cost is zero. Good for you…not so much for the government. Thankfully, we advise you. Anyone who has their taxes done through us here at the branch has this process applied to their LP investments – meaning we track and adjust the cost base. So should you or your accountant because if you don’t, you will pay tax twice!

What follows is additional wording from James Cole, Portfolio Manager for Portland Focused Plus LP. It is directly from his 2018 Letter to Shareholders:

“The LP does not pay distributions. Instead, the LP allocates its income and expenses to its investors on a pro rata basis. These allocations are recorded for tax purposes on T5013 slips which are issued to investors annually in March in respect of the preceding calendar year. One of the attractive features of limited partnerships is that income earned and expenses incurred by them retain their tax character when they are attributed to investors. For example, most of the LP’s income is tax-advantaged as it is in the form of capital gains and eligible Canadian dividends (only half of capital gains are included in taxable income and eligible Canadian dividends earn significant tax credits). At the same time, the LP’s expenses (i.e., management fees, performance fees, operating expenses and interest expense on margin loans) are all fully deductible in the computation of taxable income (with the exception of foreign dividend withholding taxes, which also earn a tax credit). For tax purposes, these expense items (other than foreign withholding taxes) are all aggregated into one number (reported on the T5013 slips) called “carrying charges”. Note that since the LP does not actually pay distributions, investors must have some other means to pay any taxes owing by them on their allocation of the LP’s income and expenses. In my experience, investors generally fund their LP-related tax obligations using other resources held by them or by redeeming some of their units of the LP.
Upon receiving each T5013 slip, investors should adjust the adjusted cost base (“ACB”) of the LP’s units that they own by increasing the ACB by the amount of income items allocated, and decreasing the ACB by the amount of expense items allocated. In this way, investors in the LP avoid double taxation (which would otherwise arise if investors paid taxes on income allocated to them but not actually received by them, and then, when they eventually redeem their units.”

Hopefully this helps. If not, please contact us and we will explain further. Whether it be a Flow Through Resource LP, Real Estate LP or the Portland Focused Plus LP, its imperative to understand the preceding and track accordingly. Many clients own these LPs and the unrealized capital appreciation is quite large in some cases. Lastly, keep in mind this only applies to non-registered (cash) accounts. Within an RRSP, RRIF, LIRA or TFSA, the above does not apply as all income generated in those accounts is non-taxable.

Written by Michael Prittie, Portfolio Manager CFP, CPCA, CIM, FCSI, CIWM

Capital Wealth Partners Nominated for “Advisory Team of the Year (Fewer than 10 Staff)”

In early spring Michael Prittie was advised that Capital Wealth Partners and in particular, our team was nominated for the award category “Advisory Team of the Year (Fewer than 10 Staff)” for the 2021 Wealth Professional Awards. As Branch Manager, Michael submitted a written response to a number of questions and highlighted our value proposition to the judges. In June, we were notified of inclusion in the finalist category. During a two-day virtual event, Michael had the privilege of speaking on a panel with a number of investment professional finalists for the purpose of judges determining a winner. Topics included how to build award-winning client engagement strategies, motivating and coaching team members, and software support. The ideas shared by fellow panelists and Michael generated lively conversation and as we move into re-opening Ontario post COVID, we look forward to integrating a few new ideas here at the branch. While we did not take the crown, the entrant field was large, the competition worthy and we were
thrilled to be within the vetted finalist group of ten.

Our thanks to those who nominated us, Wealth Professional and CMI Mortgage Investments who sponsored the panel
discussion and the award itself. Special thanks to the team here at the branch who are top notch and whose collective
traits got us to the finalist stage.

Quantitative Easing – What is it and how does it work?

The intended purpose of Quantitative Easing (QE) is to help fight deflation, spur lending and spur investment and economic growth.

Central Banks do this by trading settlement balances (reserves) for treasury bonds from the commercial banks.  These settlement balances technically are not new printed money despite appearing so. The commercial banks can lend against settlement balances or trade these balances amongst each other to settle payments. These are only used between the central bank and commercial banks.

Now as the central bank buys these bonds, in excess of regular market volume, they increase the price of these bonds and in turn, lower the yields on them. The lower yields lower the cost to borrow, which incentivizes people to spend, companies to invest into expanding/taking on new projects and these activities help grow the economy. This is the basic principle of QE.

However, since QE is still a relatively new concept, with the first case of QE being in Japan in the early 2000s, there may be some unforeseen consequences. For example, what happens if banks have tightened lending standards because we are in the middle of a recession and the interest rate premium isn’t worth the risk of default?

Generally, if an individual or company is riskier to lend to, then interest rate premium needs to be adjusted upwards to compensate for the risk of default. However, just because central banks encourage low rate borrowing it does not mean banks are forced to lend as banks don’t want to expose themselves to bad credit.  According to the US Fed total revolving credit is down almost 13% YoY or 200 billion, which is back down to what it was in 2017.

Another question is; Does QE really increase liquidity in the market?

How do reserves or settlement balances help the banks? Inventory of highly liquid bonds are used by banks that can be sold at a moment’s notice to essentially anyone. Those bonds were replaced by settlement balances or reserves, and these have limited transactional usage.

According to the US Federal Reserve, the collateral multiplier for US treasuries fluctuates anywhere from 6-9 times.  Since central banks take bonds off the market and essentially lock them up, any bond taken off the market has no multiplier effect. It is the opinion of some economists that the liquidity provided by the collateral multiplier effect is greater than the settlement balances they receive.

Western governments are incentivized to use QE since it makes it cheaper for them to borrow to cover budget deficits during times when the tax base can’t handle the load. Developing nations call it competitive devaluation. Lower bond rates force pension funds to take on higher risk to meet obligations related to pension payouts. With that being said, there isn’t a consensus among academics on the positives and negatives aspects of QE.

Written by Dusan Surla

Estate Planning for Special Needs Families

As of February 2020, there were approximately 379,000 Ontario Disability Support Plan (ODSP) members out of 4.5 million households in Ontario.  Therefore, approximately one family in twelve is a parent or sibling household of a person with special needs.  Most people who have a developmental disability live in the community in a variety of settings such as: with parents or other relatives, in group homes or in their own homes or apartment, with varying degrees of support.

Despite the wide range of supports offered in the developmental services sector, one of the keys to creating a sustainable service system is to engage in early planning with individuals and families through times of transition to make successful adjustments across life stages. 

The RDSP is designed to assist a disabled individual in saving for their long-term financial needs. It offers tax-deferral on any investment growth, access to generous government grants and bonds, and an opportunity for family members to assist with the contributions. This article explains some of the intricacies of RDSPs including who can be the holder and how the government assistance works, as well as other important estate planning considerations.

Here are ODSP updates on benefits:

Tax Credit Recaptures and RDSP benefits increase from $896 to $1169.  Disability and Caregiver tax credit 10-year recaptures are $16,000 + $9,000.

ODSP Qualification Criteria include:  Inability to function in a competitive workplace or community or handle personal care. 

Asset Limits & Monthly Benefits are $896-$1,169, plus drug and dental voluntary payments over a 12-month period are $10,000.  Asset limits are $40,000 per individual plus $10,000 to those benefit units with a spouse included.

Canada Recovery Caregiving Benefit (CRCB) is $500 per week, for up to 26 weeks starting September 27th, 2020.  These are subject to:

Note: If you were unable to work for at least 50% of your normally scheduled work week because you are caring for a dependent due to COVID/their usual care facility is unavailable.  Alternatively, if facility or care is available but you are keeping your dependent home due to preference, you are NOT entitled to CRCB.

Disability Tax Credit (DTC).  This can help you reduce taxes owing (for you or a supportive family member).  This credit can be back filed by adjusting the clients tax returns for the last 10-year period resulting in recaptures up to $20,000 (with an additional refund for up to $8,000 if you are recapturing the Caregiver Tax Credit at the same time).  Note that approval of the DTC means that an RDSP can then be openedEven if you do not contribute any money – the government will contribute $1,000 per year in bonds for 20 years.  Additionally, if you contribute $1500 per year the government will contribute an additional $3500 per year in grants for 20 years. (depending on beneficiary’s income & only until age 49).

Here is an example:

$30,000 in parental or personal contributions combined with an additional $90,000 federal government contributions compounding at 5% during the first 20 years grows to about $200,000.  Compounding again at 5% from age 18 to age 60 equals about $700,000.  This lump sum of capital could provide an annual income close to $30,000 for 25 years (age 85).

All RDSP payments paid to a plan holder (Lifetime Disability Payments) are “100% exempt” from the DSP income test – meaning that ODSP payments are NEVER reduced due to RDSP payments.

To understand how money can grow in an RDSP click this link to the RDSP savings calculator:

Other planning considerations for a child with a disability may include:

  • Power of Attorney for personal care and property
  • Substitute Decision Maker (SDM)
  • and Guardian.

Special trusts can be set up including Henson Trusts.  Henson Trust wording within a legal will must include “absolute and unfettered discretion” and “shall not vest”.   Reversal of “Even handed” rule, size of trust is unlimited and disbursements unlimited (no $10,000 limit).

Finally, if a disabled child outlives the parents and continues to be totally dependant, then one should consider purchasing permanent life insurance.  The following is an example:

      • Female, age 50, non-smoker with life expectancy of 35 years.

      • $100,000 Universal Life plan with a monthly cost of $115.40

      • To save $100,000 after tax with $1,384.80 per year at 4% it would take 41 years.

In conclusion, the RDSP is designed to assist persons with disabilities in saving for their long-term financial needs. With 1 in 12 households affected by this and the many recent government and tax changes, this type of planning along with special life and estate planning requires particular attention and should include the help of a qualified professional who specializes in this type of planning.  For any questions or to obtain more information, please call us at the branch.

Written by Shawn Ryan, Insurance and Estate Planning Specialist, CFP, TEP

Hardest Home Workout Moves

You don’t need equipment to get a great full body workout– these moves will prove it. 

Doing the right no-equipment exercises will let you target muscles you don’t regularly use when working with barbells, resistance bands and machines. If you’re looking for a challenge, here are some of the toughest body-weight exercises put together in a sequence. 

1. Pistol squat

Let’s start with the hardest. The pistol squat is a single-leg squat that calls on your flexibility as well as stability and balance. Here’s how to do it

  • Begin standing with your feet together and parallel.
  • Extend one leg straight in front of you, with your heel hovering off the floor. Raise your arms straight out in front of you.
  • Keeping your core tight and your spine straight, bend your standing leg and lower your body, keep your other leg extended in front of you. Keep standing foot flat on the floor.
  • Bend your standing knee as far as you can. The aim is to get your extended leg parallel to the floor. Straighten your standing leg to return upright, keeping your extended leg straight. Switch legs and repeat.

2. Burpees

You probably guessed that burpees would make the list. They’re hard and I’ve yet to meet someone who likes doing them. However, they’re a great cardio exercise and they work every muscle in your body, strengthening your arms, legs, booty, glutes, abs, and more. Here’s how to do it:

  • Stand with your feet shoulder-width apart, weight in your heels, and your arms at your sides.
  • Push your hips back, bend your knees, and lower your body into a squat.
  • Place your hands on the floor directly in front of your feet. Shift your weight onto your hands.
  • Jump your feet back into a plank position. Your body should form a straight line from your head to heels. Don’t let your back sag or your butt stick up in the air, these will disengage your core.
  • Jump your feet forward so that they land just outside of your hands.
  • Reach your arms overhead and jump up into the air.
  • Land and right away lower back into a squat for your next rep.

3. Mountain climbers

It doesn’t take long to feel the burn when doing mountain climbers. They provide upper and lower-body strengthening with a hit of cardio. Here’s how:

  • Start in a plank position with arms and legs long. Keep your abs tight. 
  • Pull your right knee into your chest and squeeze your abs while keeping your plank in good form.
  • Quickly switch and pull the left knee in. At the same time, push your right leg back into plank position. 
  • Continue to switch knees using a “running” motion. 

4. Broad jumps

Remember long jump from track? That’s essentially what you’re doing – jumping forward as far as possible, starting in a standing position. How to get started:
Stand with your feet shoulder-width apart. Arms in the air.

Begin by swinging your arms back behind your body as you bend your knees and push your hips back.

Swing arms forward as you drive your feet into the ground, push hips forward, and explode forward off the ground.

Land on your feet and drop back down into the starting position. Repeat.

5. Jump squats

Jump squats offer lower-body and cardio in one. You don’t need to do a ton of them to get the job done. In fact, you can add them between reps of other exercises. Here’s how to do them:

  • Stand with your feet shoulder-width apart.
  • Start by doing a regular squat, engage your core, and jump up.
  • When you land, lower your body back into the squat position to complete one rep. Make sure you land with your entire foot on the ground. Be sure to land as quietly as possible, which requires control.
  • Do 10 reps.

Written by Mia St. Aubin who was a guest speaker at our March client Zoom seminar.

Who Needs a Cash Wedge!

When preparing for an income stream at time of converting your Registered Retirement
Savings Plan to a Registered Retirement Income Fund (RRIF) or taking a systematic income
from a non-registered investment account, having a cash or income wedge is very
important. What is a cash wedge? Well, it is not related to the game of golf, however it
can definitely improve the sustainability of your income stream. This is because, when
looking at any sustainable income stream from an investment portfolio, the sequence of
returns is very important.

If you analyze two balanced investment funds and both have a 7% average rate of return
over a 20-year time frame, this is just fine in the accumulation stage (while saving) even if
the sequence of returns differs. However, in the income stage, when you are redeeming
shares and the early years are punctuated with losses (circa 2008-09) or any other
examples that come to mind, then you are exposed. This is because each income payment
requires a sell and when markets fall you need to sell a greater number of units or shares
to raise the cash required for your desired lifestyle or the minimum required RRIF
withdrawal. If the economy sours and markets fall in the early years of your withdrawal
program, then you will need to sell a great number of shares than if the market was rising
during this time. Depleting your share balance at a faster rate is not a good strategy for
sustainability and the end result is not the same when compared to period of time when
the early years are punctuated with good returns.

Enter the Cash/Income Wedge! While history has proven equites create wealth over time,
offset inflation and lower tax liabilities in a non-registered account, I suggest you set aside
at least five years of income needs in a carefully constructed wedge of short-term cash
equivalents for immediate cash flow needs, and follow that with perhaps some private
income funds, commercial mortgage pools, preferred shares, etc. to create a relative safe
wedge of capital that can be drawn upon in tough times. By separating the typical
balanced fund in to its components, and enhancing the income strategy to bring about
better yields, you can avoid selling equities during tough economic times when prices have
fallen and rely on the income wedge which is generally unaffected – thus preserving your

One Year Later, What Now?

It’s been one year since the COVID-19 pandemic has altered our world. Pat yourselves on the back, take the time to give yourself recognition for all of the obstacles that have been thrown your way and how you were resilient and able to adapt. A bit more than a year ago, we never would have known all of the physical, mental, emotional, and social tolls that this virus would have on lives. Now, let’s gain some insights into the ways in which we have adapted and incorporated them into our everyday lives. 

Ways to Stay Connected

In our virtual world, it’s all about finding ways to stay connected with your loved ones and your colleagues. Some of the notable platforms that people have embraced this past year are Zoom, Google Meet, Skype, and Facetime. No matter your preference of platform, these have become valuable tools when reaching out and checking up on your pals. Now more than ever, virtual communication is an undeniable asset both within the professional and personal landscape. To keep busy, many have found online activities to keep the friendly competition going, even if it is at a distance. For your next virtual game night, perhaps code names, trivia, or scrabble might pique your interest.

There is no doubt that this past year we have recognized the power of communication and the importance of reaching out to your loved ones. Between chatting and playing online games, it is important to remind yourself that it is okay to not be okay and to seek help whenever you need it.  Reach out to your Employee Assistance 

Support Small Businesses

Small businesses have unfortunately suffered immense losses this year due to public health regulations and stay at home orders. This reinforces the need to support local, and thankfully, there is more than one way to do so. In addition to the local food businesses, reach out to your local clothing store, cosmetic store, bookstore and just about any of your favorite shops.  If you know that you’ll be going to your favorite store when the pandemic subsides, buy a gift card. A gift card is a timeless gift, and it gives you a reason to go back and shop. Another great way to support local without leaving your house (a win-win) is to write a review about the business. Not only will this help businesses, but it might encourage others to support them. Something you always need to remember is that the store owners and their employees are community members, and they deserve to be supported.

Save! Save! Save!

Have you found that your spending decreased this year? Without daily coffee runs, after work drinks with coworkers, and an OC Transpo pass, this provides a great opportunity to save money. Maybe we’ve spent a little more on hand sanitizer or masks than we probably ever would, but if it keeps us safe – it’s worth every penny. This does not apply to everyone, but if you have some disposable income available, put it aside. If you’ve always dreamed of owning that car, paying off your mortgage, saving for retirement, or sending your kids to school – this is your chance to save for milestone expenses.

This has been a hectic, challenging, and transformational year for sure, but hey, we did it! With the vaccines rolling out slowly but surely, this gives us a glimpse of hope for the future, a world where we can be in the same room as our loved ones and squeeze them for a year-long hug. Keep smiling under your mask, wash your hands and keep your head up to tackle the upcoming year. 

Written by Catherine Hansen in conjunction with Duane Francis, Portfolio Manager, CFP, CIM, CPCA, FCSI, CIWM

Understanding IPO Performance Metrics

With the year coming to a close, we are also seeing the end of Initial Public Offering (IPO) season in public markets. Often, a firm will go public as its next step in growth, to gain access to capital markets, or if market sentiment is positive, secure a high price and reap the benefits of cheap equity capital. This year saw some notable entries into the public market to take advantage of at least one of these reasons, and two very successful IPOs were Snowflake, and Palantir, however, not all faced this same short-term prosperity.

While day one returns may be substantial, the IPO is not the be all and end all of investing. Frequently, firms tend to soar on day one, but face severe price drops in the following days, but it’s important to ask why some firms succeed long term compared to their peers who soared on day one, but saw long term underperformance. Historically, IPO underpricing has held true for highly anticipated offerings, but upon investor realization of the true intrinsic value, the price point settles to a realistic expectation within the market.

In our previous newsletter, I discussed the efficient market hypothesis and how investment prices are a reflection of all available information, both public and private. This same concept holds true to the IPO as private firms have substantially less information available on day one. As such, investors may demand the issue be discounted to reflect the risk of entering into a new security. This may be done by the issuing firm itself as it seeks to attract new investors, or it may be requested by the institutional investors that traditionally hold the majority of shares as compensation for taking on the added risk. Additionally, a financially conservative firm may deliberately underprice its offering to ensure there is no overstatement of value (under-promise, over-deliver)

Consequently, if a firm is widely sought after, the release of information to the public markets will cause this underpricing to be very prominent as day one returns rise, one such example is the public launch of Beyond Meat in 2019, but like Beyond Meat, the long-term performance of many firms following a public debut has been lackluster. Those that tend to perform best are the ones who are deliberately conservative in their valuations as day one returns may be high, but as investors price the issue, see positive long-term performance as the price rises to a true intrinsic value.

Some of the theories and implications from long term underperformance stem from three main schools of thought: 1) Divergence of opinions, 2) Market Optimism/Pessimism, and 3) Overinvestment. The first explanation of underperformance stems from the aforementioned lack of information to create an efficient price, and as excitement for the issue settles, the price also settles, and perhaps not in the way investors had hoped. Moreover, many firms will launch an IPO in an upward trending market to secure a good price, but as market sentiment falls, or perhaps economic events cause stagnated returns, the new issue will see downward pressure on its price. Finally, the third, and arguably most frequent cause of underperformance is the firm undertaking value destroying projects that are ultimately reflected in the price seen by shareholders.

While it is important for institutional, and at times retail investors to participate in IPOs, high risks are present and perhaps greater than that of an investment into seasoned securities. As such, it is extremely important to conduct appropriate research, ensure the industries in which your investments are held are well understood, and that you are paying a fair price for your investments to achieve your goals and obtain long term capital appreciation.

Written by Adam Prittie, Investment Advisor


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