Financial Jungle

The market is weird. Every time one guy sells, another one buys, and they both think they’re smart.

Being a stock picker, this is one statement that I dread the most. How do you respond when you’re cornered into a no-win rhetorical statement? Do you pretend snobbishly that you’re smarter than the other guy? Otherwise, why become a stock picker at all?

My typical response is, even though the market is smarter than I, behaviour science teaches us that the market is perpetually stuck in a moody state where traders tend to exaggerate positive and negative news. The idea of stock picking is to avoid the herd mentality, and think independently.

The point of this article isn’t whether the market is efficient. Rather, even assuming all stocks are priced at equilibrium, market participants can still reap tangible value because stocks are priced inefficiently relatively to the individuals’ objectives and holding structures. Maybe a few examples will clarify things.

I picked up 100 BMO shares a few weeks back when they announced some derivatives trading losses. Someone must have sold the 100 shares to me, but I have no clue who that was. Maybe it was an American*, which would make perfect sense due to the lack of preferential tax treatment — BMO is worth more in my hands because Canadians receive the dividend tax credit.

Or, perhaps the seller was a Torontonian. Once again, BMO is worth more in my hands since Vancouverites benefit more from a higher dividend-tax-credit rate than Torontonians.

The seller could also have been a retiree who has a much shorter time horizon and looking to swap his BMO holding to something more conservative like bonds.

How about income trusts that distribute ample of interest incomes? As most know, the government will strip the preferential tax treatment for most income trusts by 2011. In the meantime, income trusts avoid paying the corporate tax as long as they distribute all earnings to shareholders. This delights RRSP shareholders more because the resulting pre-tax distributions are generally higher and tax-deferrable, while non-registered shareholders must report the distributions as regular income for the year.

Once the rule changes in 2011, the opposite is true. Income trusts must pay corporate tax on all reported earnings, however the trusts can distribute dividends to shareholders, who can then claim the dividend tax credit. The new rule favours non-registered holders because the after-tax distributions are essentially the same as prior to the rule change. On the other hand, the new income trusts are worth less in RRSP holders’ hand because the corporate tax reduces the distributable cash, and the dividend tax credit is lost inside RRSP.

As you can see, there are scenarios where win-win transactions can take place, and I haven’t even touched on portfolio rebalancing or hedging yet. The only time when it’s a zero-sum transaction is when it’s between two investors with similar goals.

For my own purchases, I don’t worry about who’s at the other end of the trade, because we can both be right.

* Since BMO is inter-listed on both Toronto and New York, I’m not sure if Americans receive preferential tax treatments if they purchase BMO from New York.