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The new rules — an annual check up on income trusts

A year ago, a leading authority on income trusts forecast how the market would change with the coming tax. Here’s how it turned out.

It is now 2008. That means there are almost exactly three years before the tax on income trusts falls into place. Trusts have not lost their fascination for Canadian investors, but the market has changed dramatically in the fourteen months since the tax was announced.

There are fewer winners, but also fewer losers. A number of companies that were just along for the tax-free ride have abandoned the trust structure or been absorbed by their betters. Many companies that might have been tempted to join in the fun before Halloween 2006 gave up the ghost overnight.

The fewer winners are also bigger winners. To see why, we’ll get a survey of the trust landscape from a leading authority on the field, the Income Trust Guide published by the Money Reporter.

This advisory traces the progress of income trusts over the past year. The story begins at the dawning of the New Year in 2007.

Truly suited to the trust structure

“At the beginning of this year,” says the advisory, “we forecast that the coming tax on income trusts in 2011 would have a dividing effect on the overall trust market.

“There would be those trusts — a small subset of all the trusts that were outstanding — who would thrive leading up to 2011, and survive intact as trusts after that.

“These would be the businesses that were truly suited to the trust structure (every trust claimed upon conversion that they were ideally suited for the structure, a claim which become more and more laughable as less and less qualified businesses took advantage of the hot market).

“These would be the businesses with excellent management, strong cash flow, a conservative payout ratio and conservative amounts of debt. These would be the trusts that would be able to capitalize on the newly-limited ability to combine with other trusts, and to issue new units.”

Then there would be all the others, the “weak sisters,” often those who came to the market late, when the quality of firms converting to trusts was not notably high.

“Our prognostication was that a two-tier market would develop,” continues the advisory, “with the fewer strong contenders getting stronger, and the many weaker candidates either failing outright or getting absorbed by a larger, stronger trust.

“This is exactly what happened over the past year.”

Survivors vs. weaklings

The idea, from here on in, adds the Income Trust Guide, is to “identify the survivors, and avoid the weaklings.”

One of the survivors is a relative latecomer. Among a flurry of late low-quality conversions to the trust structure, CI Financial Income Fund (TSX-CIX.UN) “is such an exception in this regard that it makes the contrast even more stark.”

The advisory likes “CI’s longer-term strategy of taking on the banks and out-servicing them in the areas customers care about.” It does worry about the “short-term potholes” CI occasionally rumbles through, like its recent run at Dundee Wealth, but such diversions have not hurt the bottom line.

Over the past month, CI Financial gained an impressive 10.02 per cent while financial stocks were generally getting thumped for their indiscretions in the ongoing credit crisis.

The advisory cites several more trusts that have outdistanced their peers.

EPCOR Power (TSX-EP.UN), which this same advisory has described as a rather dull outfit, can at least claim to be dull in all the right ways. Over the past month, it gained 10.98 per cent while the Energy Trust Index was flat.

Not least, RioCan REIT (TSX-REI.UN), which specializes in retail properties, gained 5.01 per cent last month while the REIT Index as a whole was up 0.2 per cent.

In short, it is more important than ever to look for the strongest individual trusts, and not to be distracted by the general performance of this or that sector.

In pursuit of that goal, we’ll look at several more trusts this advisory admires.

Misunderstood but profitable

The advisory persists in recommending Davis & Henderson Income Fund (TSX-DHF.UN), an income trust that many are ready to consign to the back burner.

The company makes chequebooks — we all know that paper products are on their last legs, right? — and still does very well in this business. But it also operates in the twenty-first century, with an online real estate and mortgage processing business.

The advisory acknowledges wryly that it might cease talking about Davis & Henderson “when it generates a total return of less than 44%, as it did this year. It has good management, a misunderstood but very profitable business, and it offers regular distribution increases.”

Funds of income trusts are not a big hit with this advisory, with two exceptions. One is Series S-1 Income Fund (TSX-SRC.UN).

As a rule, says the Income Trust Guide, funds of trusts tend to perform poorly by spreading themselves too thinly. But the Series S-1 fund is different precisely because it holds many of the trusts the advisory has identified as strong performers.

The trust has performed well over the past year, although it dipped 4 per cent in the past month. This makes no sense, adds the advisory, except perhaps for a lack of liquidity, so a limit order is advised for those who wish to purchase the units.

The other fund of trusts recommended is the Brompton Stable Income Fund (TSX-BSR.UN). It also holds many of the trusts the advisory admires. “As quiet as this fund is, it has done a great job in 2007,” reports the advisory. “Its unit price is up 4.7 % in the past month, greatly more than the Income Trust Index, and it’s up 9.6% in the past year. Take that latter figure, add in a 6.4% current yield, and that works out to a 16.0% total return.”

Four more trusts are highlighted in this issue: a telecom, an energy trust, another REIT and a utility.

Billions of dollars looking for a home

“It’s just a matter of a few months now that billions of dollars invested in BCE Inc. will be looking for a new home,” says the advisory. Institutional investors in particular, who need to maintain their sector weightings, should find Bell Aliant Regional Communications Income Fund (TSX-BA.UN) a worthy alternative.

Those retail investors who patronized BCE for its rich dividend record will also be looking to replace that income stream. “The monthly cheque that an investment in Bell Aliant offers works out to a 9.50% annual return.” If the advisory is right, these units should be in great demand a few months from now.

Canadian Oil Sands Trust (TSX-COS.UN) “is a buy for the trifecta: for income, growth in income, and capital gains.”

After a very good 2007, the trust had a fourth quarter stumble when the Alberta government came down with its new energy royalties policy. “Now that government has apparently forgotten how much capital had to be put at risk for how long just to get the first few barrels produced, at uncertain prices.”

Nonetheless, production keeps growing and so does the unit price. “Imagine asking yourself five years from now why you didn’t buy in at these prices.” For the record, the closing price Monday was $38.55.

A new game

If you were to own only one REIT, says the advisory, it would be the previously mentioned RioCan. But next in line comes Canadian REIT (TSX-REF.UN), generally identified as CREIT. It holds a balanced portfolio of retail, industrial and office properties.

REITs in general are not hot at the moment, admits the advisory. “But there are reasons why you always want to stay diversified and hold positions in a sector even when it is down.” To reiterate: look at the strong individual trusts, not the weaker group.

Finally, Energy Savings Income Fund (TSX-SIF.UN) “is a buy for income and increases in income, with prospects for gains as the company expands into the U.S.”

This natural gas and electricity utility recently fought off a court action from three former senior employees and their new company in British Columbia. The company was ordered to suspend operations in the B.C. market until midway through 2009 and even had to remit a payment to Energy Savings. So the trust is cleared for growth.

These are by no means all of the strong survivors the Income Trust Guide has identified in the trust market. In fact, it has a list of some 24 trusts that it follows on behalf of its readers. But you get the picture.

New rules have made for a new game. Although the annual returns have yet to be measured fully the advisory’s forecast has thus far come to pass. And while the easy money ran out some time ago, it looks like there’s still big money to be had for those who trust the right trusts.