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TSX Dividend Stocks and the Demise of Income Trusts

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If you just won the lottery...

and were looking for some safe Canadian investments then skip to:
         Sooty's Investing in Canadian Banks.

If you have already read the advice (below) on TSX Trusts...

and want to just see last night's upload of suggested stocks then skip to:
         Sooty's Table of Bargain Income Trust Candidates.

Income Trusts Breaking News - Future Tax Liability Charges

June 27, 2007 - Bill C-52 received royal assent - this put the October 31, 2006 proposals into law so unless we have a change of heart (or government) Income Trusts or the more correct C-52 term SIFTs (Specified Investment Flow-Through) will be subject to a 32% tax rate.

Okay so why are "future tax liabilities" showing up on balances sheets now? For Income Trusts reporting after June 30, 2007 these can be so large they turn the stable profit reported in previous years into a loss in 2007. The answer is complex and for many trusts this new item has just made the obscure "distributable cash" method of accounting more fuzzy.

"Future tax liabilities" have shown up in the past. Al Rosen in the December 2001 issue of Canadian Business complained about these calling them a "Tax Racket" and some Trusts may use C-52 to further fiddle their books.

Most Trusts are probably trying their best to figure out how to make it through 2011 without a huge crash in the unit price. They are putting money away now so they can continue to pay out their distributions plus the 32% tax. In 2011 they would deplete this cash reserve and push the crash into 2012. If the legislation were softened or amended with some kind of tax credit the reserve could last longer. If the legislation were thrown out then they could increase distributions for many years to come.

The calculations of the amount of the tax liability are as mysterious as the calculation of distributable cash. Trusts will have to play by Revenue Canada rules on depreciation of real assets and the difference between the RC rules and the games they play now could result in a big tax bill. These tax liabilities are probably real and we may be getting a truer picture of the financial position. Intangible things like the reduction of goodwill on the balance sheet will change the financial reports (and distributable cash) but not the tax accounting calculations so they would show up as a future tax asset because their "depreciation" does not result in a tax liability (so a non-liability is an asset - with me so far?)

The bottom line is that these tax liabilities on the balance sheet are going to make the financial reports look bad through into 2011. They will definitely increase the apparent pay-out ratio and will probably depress unit prices. Should a Trusts investor worry? Yeah. We are driving headlong into a 2011 wall. If things do not change it is a concrete wall. If the legislation is softened it could be a wall made of cardboard or plywood. In any case it will be scary until we make it through.


Income Trusts Breaking News - Government Halloween Trick

October 31, 2006 - The Federal Conservative government breaks a major election promise and announces they will tax income trust distributions at the 32% corporate tax rate. The applies immediately for new trusts and starts in 4 years for any existing trusts. On November 1 the income trusts on the TSX lost a combined $22 billion in value.

Does this mean the end to income trusts as an investment vehicle? Yes. No new trusts will be formed and after four years many existing trusts will convert to some kind of dividend structure.

Does this mean you should stop buying trusts or sell off all you have. No. If you pick trusts with good underlying business models there is no reason they will not perform well over the next four years and convert to something that provides above average income flow after that.

Will the tax change happen exactly as announced? Probably not. The changes will likely be made law as part of the spring budget. Since the Liberals will have a new leader by then the spring budget will probably fail and the changes will have to wait for a new government to be formed. The tax rate will probably be less than 32% or there will be tax credits offered to Canadian taxpayers. For the trust investor "32% and 4 years" represents a worst case scenario - what actually happens will be less dramatic. As always plan for the worst and hope for the best.

Investing in Income Trusts

Income trusts as an investment vehicle have become the darling of the business news media. In some ways they look like high yield bonds with no expiry date and a potential for capital appreciation and growing distributions. What could possibly be wrong with that? The problem is income trusts are as risky as equity investments and worse yet their published reports of business performance are often misleading.

Sooty is a "value investor" which means he makes very few trades, usually buys something with the expectation he will keep it forever. He reads a lot of financial statements and economic analysis before ever buying an investment. If you are a day trader who buys on margin and trades on momentum you will find Sooty's advice boring and way too much work.

If you are still interested in income trusts you can read this cautionary lecture on investing in general and trusts in particular. Then armed with this advice you can review Sooty's daily updated picks for trusts that have sensible yields at bargain prices.

Investing is Risky

Do not invest in something unless you can afford to lose your entire investment. This is the basis for "diversification" and usually means never have any single investment larger than 5% of your portfolio, in other words hold at least 20 different investments. Diversification means more than just buying stock in different companies it means buying companies in different markets. Buying 20 different gold stocks is not diversification. One gold stock, one restaurant stock, one auto parts stock, . . . is diversification.

Investing is Emotional

You can easily fall victim to gamblers fever. Read up on what addicted gamblers do; like betting on magic numbers, doubling up on losses, playing beyond their means. Avoid such traits in your investing pattern. Do not expect to get rich quick but you can get rich slowly by investing in real businesses with real products and real customers who pay real money. When you buy lottery tickets you should expect to lose 70% to 80% of your investment - if you do not understand this fact deep in your gut you will fail as an investor.

Paying people to give you advice or do more than just buy stock for you is generally a bad thing. A mutual fund manager will take 4% off the top of a low risk investment and 7% off the top of a high risk investment. If you have a mutual fund that makes 10% and the manager takes 7% you only get 3%. His 7% is safe but your 3% is very risky. You could have done better buying government bonds that paid 4%. A $20 trading fee sounds cheap unless to do 50 trades a day. Keep your costs down by researching the huge amount of free advice that is available and limiting the number of trades you make (one or two a month is ideal).

Unsolicited free advice is generally a scam. If someone gives you a hot tip on a stock it usually means they are trying to unload it. Real hot tips are rare but they do exist. They are called "insider trading" and people go to prison for offering them or acting on them.

Compound interest and stock appreciation reduces risk if you work it correctly. If you buy $1000 in shares and they rise to $2000 they are as risky as when you first bought them. Sell half your shares and get back your original $1000. The $1000 shares that remain cost you nothing and therefore risk free. If the shares double again your investment will only grow to $2000 but if you kept them all you would have $4000. "Crap I should have never sold!" - wrong - you just made $1000 on a $0 investment. If you can make a lot of $1000 gains on $0 investments you will become very rich. Your goal is to have your whole portfolio full of risk free investments.

Income Trust Financial Statements

The financial statements from income trusts are generally bogus. Any chance to read something by Al Rosen at will be valuable research. Al is a forensic accountant who has investigated the remains of many apparently health companies with glowing financial statements and failed businesses. Al is particularly bothered by the kind on nonsense income trusts are allowed to offer as financial statements especially the "distributable cash" reports.

A short story why "distributable cash" is often bogus. I sell you a $10 trust unit in a bogus company. In the first year I pay you $0.8333 per unit and spend $0.8333 a unit on the company yacht, golf memberships, and business trips to Hawaii. At the end of the year I report the "distributable cash" as $8. We have lots of cash - in fact 80% of our market value is cash. At the end of year three the distributable cash is down to $4 and I reduce the unit distribution rate to $0.033 per month. Since everyone expects income trusts to pay out 10% the market price for the shares drops to $4. You just suffered a drop in income and a huge capital loss. At the new distribution rate of $0.40 per year it will take 15 years just to recover the $6 you lost.

There are a couple of key lessons from the story. Income trusts often have big drops in unit price when they cut distributions so you get hit twice. A drop in the balance sheet value of an income trust is a very bad sign and often means they are selling assets to pay out distributions. A drop in revenue will often predict a drop in distributions in the future so the market reacts by dropping the price. Even if the trust never drops the distribution it can take many, many years for the distributions to pay back the money you lost if the unit price drops.

Income Trust Business Models

The Toronto Stock Exchange has about 400 income trust stocks (they are listed as xxx.UN on the exchange). Most of them are real companies with real incomes but many should not be income trusts. To be an income trust you should have a business with a stable market share, controllable costs and a revenue stream that is slightly growing. The business should expect to be in this kind of stable environment forever.

A good example (not a recommendation) is Rogers Sugar (RSI.UN); everyone buys the same amount of sugar every year, Rogers has few competitors, raw materials are likely to be cheap forever and increasing energy costs can probably be passed on by increasing the price of sugar.

Another good example (not a recommendation) is Canadian Oil Sands (COS.UN); the tar sands raw materials are practically free and unlimited in supply, the major cost is energy but the final product is oil so an increase in energy costs would be balanced by an increase in oil price. There are lots of competitors but their supplies are limited and declining.

The next sensible kind of income trust is one with a fixed asset life. An oil well is a good example of this. There is a known amount of oil in the well. You need a lot of money to drill the well and after the well is exhausted it has zero value. You buy a $10 unit today and the company pays you $2 per year for 15 years until all the oil is gone. If the price of oil spikes you may get a windfall distribution but usually the investment is based on some guaranteed base price for the oil.

Income Trust Unit Price - In Theory

The price of a good income trust will depend on the prime interest rate and the riskiness of the company business model. If a trust that pays out $1 per year, the prime rate is 3% and the "risk premium" for an income trust is 7% the trust should have a $10 unit value [math: $1/(3% + 7%)]. If the prime interest rate climbs to 10% the unit value should fall to a $5.88 unit value [math: $1/(10% + 7%)]. If the prime interest rate remains at 3% but the business starts to do riskier things this will increase the risk premium to say 10% and the units would drop to $7.69 unit value [math: $1/(3% + 10%). . . there will be a test at the end of the chapter].

When the interest rate changes it is easy to see how this will affect trust unit prices. Figuring out the riskiness of the business model is where choosing an investment becomes a gamble.

Looking for Bargains

You can buy safe income trusts but you will probably pay too much and the income rate from your investment will be low. You want to "buy low and keep forever". You want are income trusts that have secure distributions but appear risky so their unit price is depressed.

Now we are walking onto thin ice. How do you know that the distributions are not at risk if you cannot believe the income trust's financial statements? Go read Al Rosen again. What you have to understand is that most income trusts are real companies and there are lots of people; owners, big investors, employees that have a stake in making sure the company keeps operating. There is nothing certain.

If you were are big investment company you could go and interview the CEO and some of the employees and have a better chance at making a good decision. You could hire a big investment company to do your investing they will make the money and you will take the risk. So you are on your own with limited information. This is a risky adventure.

Steps in Finding Bargains

  1. Apparently risky trusts have depressed unit prices compared to their distributions. So sort the all the 400 TSX income trusts by percent income (distribution/unit price) and look at the ones at the top. Anything below 12% are probably not a bargain and anything over 15% are probably in real trouble. This should reduce the 400 TSX income trusts to about 40 candidates.

  2. Take your 40 candidates and sort them by how much of their earnings are being distributed. Ideally they should be distributing about 70% of their earnings. The rest should go into building cash reserves or expanding the business. However we are looking for bargains so we expect there was some kind of earnings problem. We will accept anything between 50% and 150% for distribution/earnings. This should reduce our candidates to about a dozen.

  3. Now the hard work begins. For each of the candidates you need to find out why the market thinks the company is a risky investment. Some quick tests are:

    • Drop in balance sheet assets. Perhaps this trust is selling assets to pay distributions. After a while there will be no assets and no company.

    • Drop in revenues. If the drop is a permanent change the trust will have to drop its distributions in the future. Maybe the market has anticipated this.

    • Increased competition. Is there a new company taking away market share?

    • Economic decline. Is the whole industry segment in trouble? Perhaps people have stopped buying buggy whips (or SUVs).

    • Financial problems. Does the company have a lot of debt (bonds or loans) that have to be paid off soon?

  4. If you cannot find anything obviously wrong with the company read the news releases for the candidate trust and its competitors. Check out free information on investor web sites like Report on Business TV or Globe Investor.

  5. If the available information tells you that the market has the wrong price for the trust it is time to place your bet. An efficient market is never wrong about the price so in your arrogance you have decided the market is not efficient and you know something that the market has missed. However strongly you believe you have found a bargain as a matter of discipline keep your investment below 5% of your portfolio value.

  6. Keep track of your investments. Have a spreadsheet with the original cost and the accrued income. Calculate a "residual price" for the units. If two years ago you bought a $10 unit that paid $1 annually your residual unit price is $8. Ignoring "opportunity cost", taxes and "discounted net present value" calculations your residual price is a good measure of your risk. When the accumulated distributions push the residual unit price to $0 your investment is risk free. If the market is willing to pay you $20 for the units - sell half of them and instantly force your investment into a risk free state. Actually if your residual unit price is $8 then you should probably sell half your units when the market price hits $16 (Why ? I told you there would be a test).

Your Goal
Your goal is to find bargains - that is stocks the market has under priced. Hold these (or sell half of them) so you can turn them into risk free investments.

Candidate List from TSX
I have a little system of programs (C++, VBS and ABAP) that scrapes TSX and Globe Investor web sites looking for bargain candidates. These are NOT recommendations they are just income trusts that my automated programs have uncovered by performing steps 1 and 2 of the "Steps in Finding Bargains" process.

You are welcome to investigate any of these candidates as a starting point for doing steps 3 through 6. Re-read my advice that "Unsolicited free advice is generally a scam". Assume I have bugs in my programs or I have fiddled with the results to induce you to buy units I am trying to unload or paid to promote. A little paranoia is good for the careful investor.

Still interested? . . . then proceed to:
         Sooty's Table of Bargain Income Trust Candidates.