Trusts are bought for their yield, for the monthly income promised to unitholders. So doesn't it just make sense that the best trusts boast the highest yields?
Not at all. Focusing exclusively on yields, on units that promise the biggest income bang for an invested buck, is a strategy that's bound to backfire. The reality of today's market is trusts with the highest yields are the most likely to disappoint.
More often than not, soaring yields signal a business is stumbling, and a trust's all-important distributions are about to be cut. The income trust hall of shame is rapidly filling with companies that boasted sweet double-digit yields just before they took the axe to investors' income.
Legacy Hotels Real Estate Investment Trust led its peers with a 12.8-per-cent yield just two weeks ago. It dropped to the back of the pack by suspending distributions, as severe acute respiratory syndrome (SARS) and the weak economy kept guests away from its hotels.
Setbacks like this haven't stopped investors from reaching for yield, the experts say, by setting aside common sense to buy companies that hold out the promise of more income.
'Investor appetite for yield is at an all-time high, all sorts of studies have shown. You can see that in the popularity of high-yield funds, dividend funds and trusts,' says Ben Cheng of CI Fund Management. (John Hryniuk/The Globe and Mail)
"Investor appetite for yield is at an all-time high, all sorts of studies have shown. You can see that in the popularity of high-yield funds, dividend funds and trusts," says Ben Cheng, a mutual fund manager who holds more than $1-billion in trusts at CI Fund Management. Yet veteran investors say yield is the last thing they look at when deciding which trusts are worth holding.
"The yield is your destination when you're looking at valuing a trust. The journey is more important, where you look at the quality of the business and its management," says Oscar Belaiche, a Goodman & Co. money manager who also has more than $1-billion tied up in trusts.
The mistake many investors make is treating trusts as a substitute for bonds in their portfolios, a source of extra income at a time when interest rates are at all-time lows.
"Investor due diligence usually stops at the cash yield now being offered by a trust," says Adrian Mastracci, at KCM Wealth Management Inc. in Vancouver. "Investors forget that trusts are really equity instruments, as opposed to fixed income securities. There is little fixed about them."
In fact, trusts are high-yield equities. The income they throw off, and the underlying price of their units, moves in step with the prospects of the underlying business. That means some trusts are bound to stumble, just like any other company. And some are likely to deliver on, or exceed, their promise of cash distributions to unitholders.
"There are good trusts and bad trusts, just like there are good and bad companies," Mr. Belaiche says. "Our fundamental thesis is we buy good businesses at a reasonable price. We do not buy marginal business because they seem cheap."
In general terms, power companies are considered the safest trusts. These utilities are the most likely to keep their distribution promise.
Energy trusts are at the other end of the spectrum, as the most likely to burn investors. In large part, that's a reflection of the trusts' enormous exposure to moves in commodity prices. The risks and rewards of business trusts rank in between the power and energy trusts.
To compensate investors for putting their money on the line, yields range from 6 per cent in the strongest business trusts to highs of 16 per cent for the riskiest ventures. Yields in the business trust sector average 11 per cent. Energy trusts are averaging 18-per-cent yields these days, with oil and gas trusts considered likely to cut distributions in the face of declining reserves or falling oil prices, or both, yielding more than 20 per cent.
Like many investments, trust yields should be looked at with a view that if it sounds too good to be true, it's probably not true.
Now, here's the good news. The income a trust kicks off gives it an enormous performance advantage over other equities.
"For most investors, the choice between owning a trust and a regular stock is like a golfer's choice between hitting from the ladies' tees, or the back golds that the pros use," says Ira Gluskin, who holds $200-million worth of trusts at money manager Gluskin Sheff + Associates Inc. "The 10-per-cent yield on a trust is like teeing off 130 yards up the hole."
Picking the best trusts boils down to picking out which businesses make money in good times and bad, says Leslie Lundquist, a money manager at Bissett & Co. in Calgary. "My first priority is establishing the ability of the underlying business to continue throwing off cash, over time."
Making this call often boils down to finding quality management, something that doesn't show up in quarterly reports or an initial public offering prospectus.
"Prospectus-level disclosure can be tough to decipher. A prospectus is good as far as it goes. It's all in line with GAAP [generally accepted accounting principles] and other standards. But it can't give a good picture of where the underlying business is going," Ms. Lundquist says.
"The challenge in an IPO is to figure out what management is not telling you, what they are glossing over," says Bradley Dunkley at Gluskin Sheff. "We quiz management on their prospects, the competitive barriers to entry in their business and the potential for organic growth, or growth through acquisitions."
There are tools to help investors do this work. Rating agencies Standard & Poor's Corp. and Dominion Bond Rating Service Ltd. both rank trusts on their ability to keep making distributions.
The ratings focus on seven key components of the trust, including asset quality, market position and financial flexibility. The agencies then assign a rating that speaks to a fund's ability to sustain its distributions. These ratings are on the agencies' Web sites, and are typically included in the trust's marketing material.
What other tools can an investor bring to bear on trusts? Here's a list of what the pros look for when they weigh buying a trust.
Are the manager's interests aligned with those of unitholders? This means compensation for management must offer an incentive for handing out cash in distributions, and keeping the business going in the long term, with the capital spending needed to maintain the unit price.
If management is only paid to increase distributions, there's a danger it will run down the company by not reinvesting.
Watch for trusts that reward performance that's not in the unitholder's best interest. Legacy REIT and several of the energy trusts have been faulted for paying acquisition fees to their managers, which may encourage deal making for its own sake.
Is management internal? As a rule, managers working with the trust are preferable to external managers. If the managers are at another company, investors should question who they are working for. "We're generally comfortable with corporate sponsors who are also large shareholders, such as Bell Canada or Abitibi," Mr. Belaiche says. He said these outside managers also hold enormous stakes in the trusts, which aligns their interests with those of outside investors.
If yield isn't the right number to look at, what is? Many money managers start checking out trusts by comparing their enterprise value to EBITDA -- earnings before interest, taxes, depreciation and amortization.
Ms. Lundquist says the enterprise value is typically eight to 10 times EBITDA. Above this ratio, a trust is getting expensive in investors' eyes.
What's the payout ratio? This measures the amount of cash handed out to unitholders as a percentage of the total amount of cash generated by a business. Investors want to see a number that's under 100 per cent, signifying that the managers have some margin of error for running the business, capital spending and maintaining distributions.
Are the good times good enough to get through the bad times? Almost every business experiences seasonal sales. That's certainly true at Sun Gro Horticulture Income Fund,which sells peat moss to gardeners. "We sold Sun Gro when sales during their peak period came in under expectations, though sales were well above what they needed to hit distributions," Mr. Bradley says.
A few months later, Sun Gro units tanked when the company announced that weak winter sales had forced it to tap a line of credit to make the promised distributions.
How does the trust's value compare with Canadian and U.S. public companies in the same sector? If the rest of the oil patch nosedives, energy trusts are also going to lose ground. Mr. Cheng says: "In a trust IPO, you wouldn't want to pay a lot more for the company than a strategic buyer would pay in a takeover."
Is the company dependent on the patronage of just a few customers? If one customer represents more than 20 per cent of revenue, a red flag goes up. Trusts such as Halterm Income Fund, which ran the Halifax port, and airport warehouse owned IAT Air Cargo Trust ran into trouble when key clients either moved on or stopped paying their bills.
It's also important to ask whether the trust is in a sector that promises dependable cash from revenue. Restaurants and truckers are among the newly hatched trusts in cyclical sectors. Ms. Lundquist says: "I wouldn't buy a trucking company. It's one of those business lines that just shouldn't be in a trust."
Is the company large enough to withstand unexpected downturns? Many of the trusts created out of conversions by public companies are extremely small, including Big Rock Brewery Income Fund, with a $44-million market capitalization, and auto repair chain Boyd Group Income Fund, a $27-million concern.
The track record for small trusts contains some car wrecks. Request Seismic Surveys Ltd. was a small oil services play that became a trust, and didn't have the resources to withstand an oil patch downturn. Ms. Lundquist says: "Buying Request was the worst investing decision I've ever made."
What protection from competition does the trust enjoy? The best trusts are monopolies, protected by barriers such as capital costs, regulation or less tangible walls such as a strong brand name. Such protection is part of the attraction at pipeline and power plant trusts.
Does the business generate enough money to fund capital spending and distributions? Mr. Belaiche notes: "There is no company in the world that doesn't need to put money back into the business."
Are you getting portfolio diversity? If you already own four REITs, what's the value of buying another? The pros look for a mix of businesses and energy trusts in their holdings. They also want any trust to represent a geographically diverse company, to lessen the risk of cash flow being hurt by problems in one region -- think of Legacy's pain after SARS emptied Toronto hotels.
Finally, don't be disappointed if you buy trust units, and the price doesn't do much. Remember, trusts are meant to throw off income. A unit that makes regular, predictable distributions, but doesn't budge off its $10 IPO price is doing what it was meant to do.
Income-seeking investors want trusts in stable businesses, with a track record for always handing out the cash. An investor with this goal would probably steer clear of trusts in cyclical, trendy or competitive businesses.
"Once you've picked a diversified group of trusts, let 'em ride. The price may go up or down somewhat, but the flow of income will continue unabated if you've picked well," Ms. Lundquist says.
High yields aren't always desirable when selecting an income trust investment. These securities, like all others, frequently offer a classic risk-reward tradeoff.
RANKED BY YIELD
Yield, % as of TOP 20 Business May 30, '03 Paramount Energy Natural gas production 24.2 Harvest Energy Oil & gas production 23.5 APF Energy Oil & gas production 22.8 Viking Energy Oil & gas production 22.6 Ultima Energy Oil & gas production 20.8 Provident Energy Oil & gas production 20.8 Shiningbank Energy Oil & gas production 20.5 NAL Oil & Gas Oil & gas production 19.7 Pengrowth Energy Oil & gas production 19.5 Acclaim Energy Oil & gas production 19.0 NCE Petrofund Oil & gas production 18.0 Prime Restaurants East Side Marios, various pubs 17.6 Advantage Energy Oil & gas production 17.0 Cathedral Energy Serv. Drilling services 16.8 Vermilion Energy Oil & gas production 16.0 Bonterra Energy Oil & gas production 16.0 Rainmaker Film post-production 15.7 Boyd Group Collision repair 15.6 SFK Paper & pulp mill 15.0 PBB Global Logistics Moves business materials 14.9 Northland Power Electricity Producer 8.4 RioCan Real estate 8.4 H&R Real estate 8.4 Connors Bros. Fish products 8.3 Northern Property Real estate 8.3 Atlas Cold Storage Cold storage 8.3 Fort Chicago Pipeline 8.1 Cominar Real estate 8.0 Great Lakes Hydro Electricity 7.9 TransAlta Power Electricity 7.8 Residential Equities Real estate 7.5 TransCanada Power Electricity 7.4 Canadian Apt. Prop. Real estate 7.4 Bell Nordiq Telephone network 7.1 Gaz Métropolitain Gas transmission 7.1 North West Co. Retail 6.7 Labrador Iron Ore Iron ore 6.5 Energy Savings Natural gas, electricity 6.0 Canadian Oil Sands Oil sands production 5.0 Halterm Shipping terminal 0.0
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A matter of trust
Monday
- How trusts are transforming Canada's equity market
- It's all about tax
- Foreign ownership
Tuesday
- The Kingmakers
- Is the TSX still relevant?
- The business trust boom
Wednesday
- Reliable REITs
- Management fees can be key
Thursday
- It all started with energy
- Reserve committees a sign of maturity
Today
- An investors guide
- Decoding a prospectus
Tomorrow
- The funds of trusts
Read the series so far at http://www.globeandmail.com/business
