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
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
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
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
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
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
www.rosen-associates.com 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
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 www.tsx.com 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
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
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.
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.
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?
- 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.
- 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.
- 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 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.