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Gal^Stad
Investments Inc.

spacer January 2006
Commentary

Income trusts should be a major story in 2006. And notwithstanding a little RCMP investigation, there is so much in this sector to feel good about. Take, for instance, the stock brokerage firms and investment bankers who implored the government to maintain these financial instruments, lest the defenceless senior citizens who own them have to consider cat food a delicacy.

Good thing, too, because seniors across this great land of ours have seemingly become as ecstatically addicted to trusts as felines to catnip.

Ottawa, after much fretting and protesting about the endangered flow of dollars to federal coffers, committed The Big Waffle, allowing the existing regulations to stand for now. And just to keep things "fair," the Goodale Gang lowered the tax rate on dividends -- further stanching the flow of funds to government coffers. How illogical is that?

The upshot is that trust IPOs have been breeding like rabbits gone amok, while an insatiable public can't get enough.

How quickly things change. Around the millennium, as technology stock valuations grew by leaps and bounds, dividend-paying stocks were written off as relics of the Stone Age. Around that time, Benj was coining one of our favourite lines: "Dividends help me to be stupid longer."

How true it remains: if a stock price does not reach the target price for years and years (if at all), at least one can take solace in the annual payout. Of the stocks currently in our portfolio, more than a third pay dividends. In our point tally assessment system, a point is awarded to companies that tip their hats to shareholders in this way.

When tech was pummelled to the canvas, investment bankers recognized that it was necessary to find another golden goose to pay for the Lamborghinis, and investment trusts, with their high dividends -- er, distributions -- fit the bill. "Hurray!" responded the public, faced with barren returns on their GICs and like-minded investments. "Sounds mighty attractive to us!"

The history of these investments in Canada would fit a slim volume. It begins in 1985, with Enerplus, through which Marcel Tremblay and John Brussa pursued a strategy of selling aging oil wells to retail investors.

In 1995, when Labrador Iron Ore Royalty Trust was spun off from Norcen Energy Resources, the first mining trust was born; two months later, there was the first corporate conversion: Enermark Income Fund, which was devised to avoid the company being gobbled in a hostile takeover. Today, there are about 250 business trusts, with lots more in the pipeline.

Why are they so popular? Well, for those in the finance industry pushing the IPOs, the rich fees cannot be overlooked. Owners of enterprises love them because of the jackpots they receive, which are much higher than the prices professional buyers would pay.

Lawyers and accountants also reap revenues from them. Once you get past all that (easy, eh?), tax advantages are at the core -- and, all things being equal, these accrue both to the operating entity and to investors.

The names themselves -- "income trust," "real estate investment trust" -- seduce many investors into thinking that they offer very limited risk. If only it were so.

Income trusts have become so a la mode that they are now included in the S&P/TSX Composite Index. Some investors might instinctively be reassured by this. Unfortunately, while the index does have extensive rules and methodologies, not enough attention is paid to an astute analysis of balance sheets, financial ratios and the potential for ongoing success.

This is not to put the kibosh on the whole trust sector, because there is no question that there are some that make perfect sense. The best have stable, dependable cash flow and income, as well as reasonable payouts, far below cash flow.

Debt loads should be nominal, and assets must be plentiful enough that the rate of depletion is not a significant danger. Ideally, the underlying business will not be cyclical, and economic conditions will not have a major impact.

Changing interest rates will not quash them. Capital-spending requirements should not be onerous.

Many of the newly minted issues are not of this ilk, and to add insult to injury, they are bundled up and sold when the enterprises are near their peaks, garnering the greatest riches for the sales people.

Want an example? The first trust to go bankrupt was Heating Oil Partners Income Fund, three years after the initial offering. When this turd was foisted on an unsuspecting public, it had lost money for three straight years.

After the IPO, it lost money for three more. A year before the grand finale, $30.2 million worth of additional units were sold. What could those making the offering have been thinking after so many years of losses?

Perhaps, like a hometown announcer commenting on a batter in a major slump, their attitude was, "Hey, he's due." Or maybe, all they could see were the banking fees of $9.3 million.

Now that the sector is in a veritable frenzy, even Air Canada is getting in on the act. This IPO is the farthest thing possible from what a trust should be. It's hard to imagine who might sell this piece of bird splat with a straight face, but CIBC World Markets and RBC Dominion Securities will step up to the plate.

The current distribution, in the range of 9.5-10.5 percent, won't last -- we're as certain that it will be vastly reduced, if not all the way to zero, as we were when we pronounced Air Canada an excellent short on ROB-TV.

To prevent the further bastardization of this sector, and thereby protect investors, we thought it would be useful if there were certain preconditions that must be met before an income trust can be formed.

1. The organization must have existed as a stand-alone entity for at least five years. Rationale: Without a track record, it is difficult to anticipate future performance.

2. Neither the trust nor its parent can have gone bankrupt for at least ten years. Rationale: If this has happened, one can assume that the enterprise is not stable.

3. It must have been profitable for a minimum of four of the past five years. Rationale: We'll allow one bad annum, but any more than that and it should still be a corporation -- but heck, it can still pay dividends.

4. In four of the past five years, the enterprise must have had a net profit before tax equal to or greater than the proposed level of distributions. Rationale: Inability to sustain distributions is the bane of these organizations.

5. If a trust eliminates payouts within five years, those involved in issuing the trust must use fees earned to cover half the distributions that would have been paid (based on the initial distribution), to a maximum of those fees. This will help to insure that the issuing organizations truly do their due diligence before selling these offerings.

Will our recommendations be followed? We hear the guffaws from the peanut gallery. However, if major investor grieving in 2007 follows the record number of IPOs in 2006, the popularity of trusts will sink like a stone.

That would ultimately spur some new regulations to protect clients, but it's a pity that regulators will only be moved to action after the wreckage has occurred and the movers and shakers have moved on to the next big thing.


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