It’s that time of year again. Stone Asset Management is heavily engaged in the marketing effort for its Stone 2013 Flow-Through Limited Partnership.
In the past 11 years, the Toronto-based fund manager has raised $200 million from the creation of 16 limited partnerships. They consist of a portfolio of flow-through shares in Canadian resource companies, and combine tax breaks with an opportunity for capital appreciation.
“It is a product that is highly desired by the market, given its tax benefits,’’ said Michael Giordano, vice-president, investments, Stone Asset Management in an interview with Stockhouse.
He said Stone aims to raise up to $20 million each year from limited partnership investors who receive a 100% tax deduction for the amount invested. After a 2-year hold period, the limited partnership gets rolled into a resource-based mutual fund.
Below, Giordano talks to Stockhouse about the importance of flow-through financing and limited partnerships to the Canadian resource sector.
What role do flow-through limited partnerships play in the resource sector in comparison to other kinds of financing?
The partnerships play a very important role, given that some of the juniors are having trouble raising money. They have resorted to selling joint ventures or royalties in their properties. We believe that flow through investing is one of the cleanest ways of raising money for junior resource companies. It helps them put money in the ground, and develop their properties.
At its basic roots, what is a flow-through fund?
Flow through is one of the few remaining tax-assisted partnership investment vehicles available to investors. You might want to call it a tax shelter. They exist to incentivize investors to invest in the resource sector in exchange for a tax break. This is because the Federal government realizes the importance of financing junior resource companies and giving that tax break to investors. Ottawa knows that down the road this could lead to job creation and ultimately more employment, and ultimately the creation of new taxes. That’s how it works. It is basically 100% deductable to the investor. We take that money and deploy it in the resource sector, investing in oil and gas, mining, base metals and renewable energy. We roll the partnership into a mutual fund after two years.
What are the benefits of flow-through fund ownership?
The key benefit is the 100% tax break. The advantage of buying a limited partnership like ours is that you get diversification. We are not investing in one particular name. Instead of investing directly in the issuer, throwing all the eggs into one basket, investors can buy a diversified portfolio with us. In doing so, you get the professional portfolio management as well.
I have been running the Stone partnerships for eight years. So I have the expertise in running this particular fund as well as its prospectus offering. The exit strategy is a benefit because it rolls into a mutual fund with no tax consequences to the investor. It is a smooth transition from our flow-through fund to a mutual fund.
How do flow through funds offer tax incentives?
They offer tax incentives because the investor in a flow through fund gets a 100% tax break. When we make an investment with the individual company (the issuer) the taxable exploration expenses flow through to us, it then transfers to our end client. We are basically buying the expenses from the issuer.
What type of investor could take advantage of tax breaks?
The flow through funds target people who need a tax break. That might include people with high employment income and limited deductions. When you are employed, there are very minimal deductions available. Sometimes, people have large capital gains in a particular year, or they have a one-time sale of a business, or they have some kind of severance package where they need a one-time tax vehicle to help write off some of that large income that they will be reporting.
Also, if someone wants to collapse an RRSP or RRIF and they are taking money out, they might want to use a flow-through partnership to offset whatever they are taking out. This is because they going to get taxed on whatever they take out.
Say someone has $500,000 of employment income. It’s not like you can do a $100,000 RRSP. So you may want to buy some flow-through to offset that the income tax bracket that you are at.
What is meant by active management?
Active management means that throughout that two-year hold period, we are actively managing the fund. We are selling some of the junior caps and moving into some of the larger more liquid names.
We think active management is important because we are de-risking the portfolio, making it ready to roll into the next version, which is the mutual fund.
Where does an active portfolio manager look to add value?
We are adding value via the due diligence that we do when we buy companies. We look at the management team and its ability to execute in getting the property up and running. We look at the property and decide whether there is proper infrastructure in place, including roads and power lines.
We also decide when to sell. If companies aren’t performing, then we will start exiting the position in a timely manner. That is how we tend to add valuethrough professional portfolio management.
Why is active management important in light of the types of companies that funds invest in?
These are typically junior resource companies. They are quite volatile. You have to manage the activity that goes on in these companies. You add value by knowing what is going on with these companies, day in and day out and then knowing when to hold them and knowing when to fold them, so to speak.
What successes have you had with your investments?
In the large cap space, companies such as Tourmaline Oil Corp. (TSX: T.TOU, Stock Forum) or Paramount Resources Ltd. (TSX: T.POU, Stock Forum) these are companies that were financed through flow-through and they are multi-billion market cap companies.
Companies like Sabina Gold & Silver Corp. (TSX: T.SBB, Stock Forum) and Trevali Mining Corp. (TSX: T.TV, Stock Forum) have also benefitted from flow-through financing. Their objective is to either put the money in the ground and increase the resource, or get a mine up into production.
How does Stone fit into the flow through picture?
Stone is a niche player in the flow through picture. We don’t raise large amounts of money. We are not the ones that raise $100 million. If you raise $100 million, you have to buy every single deal that is out there, or every flow-through that’s available. So as a small player, we are able to pick and choose which ones we will invest in. We think that that’s very important in terms of selective management. When you are exiting the position, the smaller position will be easier to exit.
The diversification is very important. Some of our competitors will throw everything in the energy space, or everything in the metals space. We are diversified right across the board.
How many limited partnerships do you have?
We typically have one per year. But if the market is healthy, we may come out with another one in the fall. So we tend to do one or two each year, depending on the market.
When can investors buy into your funds?
They can only buy when the deal is open. So they only have until the end of February.
How do you see the pricing environment for flow through funds?
We think there is an excellent environment now because the supply/demand situation in the commodities sector continues to be healthy. We are seeing macro-economic growth from the Bric countries (Brazil, India, Russia and China), and the U.S. economy which is recovering.
On the supply side, the resource sector is challenged by geopolitical tensions, which makes it harder to get resource out of the ground. So supply/demand fundamentals look good.
Meanwhile, junior equities have been so beaten up, it’s hard for them to raise money. So it will be easier for us to get a better discount when we are buying up some of these companies who need the money.
Is today a buying or selling opportunity?
I believe it is a buying opportunity in light of those three factors, given that commodity markets still look good and equities have underperformed the underlying commodities. There is a disconnect between where commodities are trading in comparison to what the equities are trading at. So equities are cheap.
The fact that junior resource companies can’t raise money means that it’s easier for us to pick and choose which companies to invest in. For that reason, I think it’s an excellent opportunity.
How would you rate demand in the resource sector in the past couple of year?
We have seen demand of a super-cycle type strength. In China, you are seeing tens of millions of people migrating to the cities every year, and the massive infrastructure build is continuing. They are building 50,000 kilometres of high speed rail lines, as well as 200,000 kilometres of transmission lines. Admittedly we have seen an economic slowdown in China with annual GDP growth falling to 7.9% growth from over 10%. But the economy is still growing. So we think the commodities space still has legs.
How does supply rank in relation to demand over the same period?
Supply always manages to keep pace with demand because there is a price for everything. If the demand is there, producers find a way to pull resources out of the ground. But we have seen the cost curve go up right across the board in relation to the extraction of all minerals, whether it is oil and gas or base metals.
You have higher energy costs, higher labour costs, higher taxes all driving the cost curve higher. But supply manages to keep up.
What has this meant for commodity prices over the past couple of years.
Commodity prices have stayed relatively high. Oil is over US$90 per barrel. Copper is over US$3.50 a pound. This certainly proves that there is demand for commodities. If we were really worried about the commodities sector, prices would be nowhere near where they are right now.
Have equity values in the resource sector kept pace with commodity values??
We have seen oil prices and commodity prices skyrocket. But the equity prices have not. There are various reasons for that. First and foremost, investors are not convinced that commodity prices are going to stay at these levels. We think they are. There is also concern that management is not able to execute and get certain commodities out of the ground in a profitable manner. Companies like Kinross Gold Corp. (TSX: T.K, Stock Forum) (NYSE: KGC, Stock Forum) and Barrick Gold Corp. (TSX: T.ABX, Stock Forum) (NYSE: ABX, Stock Forum) continue to disappoint and investors say forget it, I would rather own the commodity than the individual company.
What does this say about value and opportunity in the space?
It is an excellent opportunity, because the macro environment continues to prosper. But the underlying equities don’t reflect this. We think it’s a good opportunity to be here.