Be wary of flow-throughs

I have received several inquires about flow-through shares in the past couple of weeks, including requests for specific recommendations and for my comments on certain issues. This is a little unusual for this time of year because the hot market for flow-throughs is usually in the fall. However, we’ve seen a rash of offerings since Jan. 1 and the reports I get suggest that they are selling very quickly.

There may be a good reason for the early rush to snap up investors’ dollars. Oil and metals prices are high right now. They may not be in the fall, which would dampen demand. So if you’re a promoter you want to strike while the iron is hot.

Conversely, potential investors should be very careful. Flow-through shares are risky at the best of times. They are even more so when you buy at what could be the top of the market.

For those who don’t know what flow-through shares are, think of them as a hyped-up version of an income trust, with more bells and whistles attached, as well as more restrictions, attached. The typical flow-through share issue invests in a pool of junior energy or mining companies – a sort of venture capital fund, if you like. These companiebring with them various tax write-offs in the form of exploration expenses, development expenses, and the like. These are passed on – “flowed through” – to shareholders who can use them to claim deductions on their returns. That’s the marketing pitch.

The hope is that once you have made use of your tax credits the underlying stocks will perform well and you’ll enjoy a hefty capital gain down the road. But of course there is no guarantee of that. I have seen many flow-through issues end up with big losses at the end of the day, offsetting the tax breaks and more.

Right now, promoters of these issues can tell a great story because anyone who bought last year or the year before has likely done well. Shareholders in last year’s NCE issue, for example, have already begun to receive capital gains distributions, long before they were expected. The reason, of course, is the strong prices we have seen for minerals and energy, the two mainstays of the flow-through sector.

That was then. This is now and we may be at the peak of the commodity cycle. Oil prices have slid sharply recently. Gold has also been in retreat. The boom may be winding down. Even if it isn’t, you should be aware that when you buy a company’s shares as part of a flow-through issue, you are paying a premium over the cost in the open market. That can be as high as 30%, which is a lot considering the market is already expensive. So be cautious.

If you still want to invest in a flow-through issue, here are some things to look for.

The premium. How much are you paying, on average, over market? If you can’t get a clear answer to this, look at other options.

The manager. Some companies have an excellent track record in their previous flow-through offers. One of them is Creststreet, which is promoting a $40 million limited partnership that will focus on the natural gas sector. It’s worth a look, although there probably isn’t any left. Another is Front Street Capital which has a mining/energy flow-through issue. Please note that I am not formally recommending either; these are just examples of respected management firms and there are others.

The record. Look carefully at the results of previous issues from the manager. Pay special attention to the periods after market peaks. For example, how did they perform in 2001 and 2002?

The terms. All flow-through deals lock in your money for a period of time, at least two years. Make sure you fully understand this and see what the exit strategy is when the lock-in period is over.

The risk. These investments rank near the top of the risk pyramid. Don’t let the tax breaks and the prospect of big capital gains blind you to the potential downside. You should be doubly cautious if you are thinking of using borrowed money to invest.

Finally, before you make any commitment get independent advice from someone you trust. That does not include brokers who aggressively tout the advantages of these deals while minimizing the possibility of loss. Remember, they stand to earn a healthy commission if you buy so they aren’t exactly unbiased. A good broker will lay out both the pros and cons very carefully, and will emphasize the risk so that you fully understand what you’re getting into. That’s someone worth paying attention to.

This article originally appeared in the Internet Wealth Builder, a weekly e-mail newsletter that provides timely financial advice from some of Canada’s top money experts. For more information about becoming an Internet Wealth Builder member, go to