How to snare a super dividend yield
After the market crash there were lots of safe, super yields, says this U.S. expert. Among the few left are two Canadian income trusts.
A big dividend yield is awfully tempting. Too tempting at times.
Borrowing from the poet who said, “To err is human; to forgive divine,” one expert puts it this way:
“Being drawn to high dividend yields is human. What’s divine is ensuring a healthy, growing company is writing the checks.”
The expert is Mr. Roger S. Conrad. Writing in Personal Finance, this U.S. analyst has firm opinions on the do’s and don’ts of dividend yields. As a student of income investments, Mr. Conrad also happens to be America’s foremost expert on Canadian income trusts.
And he has two high-yielding Canadian trusts to recommend — one in energy and one in real estate. We’ll get to those in a minute.
But first, the whole knotted question of dividend yields.
Safe, super yields
The best thing about a high dividend yield is that you are paying less for the income you receive.
The worst thing about a high dividend yield is that your shares may be getting too cheap for comfort.
It’s nice to pay less for the shares that bring you dividends, especially if you are accumulating shares over time, but if the price of a high yield is a steadily falling share price, it’s obviously not worth it.
In the wake of the credit crisis and the stock market crash of 2008, there were plenty of high yields even among solid stocks and trusts that got steamrollered with the market.
That has changed. “After 2009’s torrid gains, safe, super yields are few and far between,” says Mr. Conrad. But there are exceptions to the rule.
But those exceptions should not make you lose sight of the rule, this expert insists. It cannot be stressed too often, he says: “If you’re going to shop for yield, you’d better pay attention to who’s writing the checks.”
Super at 11 per cent
In this case, there are two sturdy trusts writing the checks. The first is not exactly a household name, even in Canada.
Zargon Energy Trust (TSX-ZAR.UN; OTC-ZARFF) describes itself as a small to intermediate firm. It explores, develops and produces oil and gas in the Williston Basin (which stretches from Montana and the Dakotas into southern Saskatchewan) and the Alberta Plains.
The yield is certainly “super” at 11 per cent. Is it sustainable?
Well, begin with the fact that Zargon is one of only three energy trusts not to cut its dividend in the past 18 months. (The others are Vermilion Energy Trust (TSX-VET.UN) and Crescent Point Energy (TSX-CPG), which converted back to corporate status without cutting its distribution.)
Based on its distributable cash flow, Zargon’s payout ratio was only 62 per cent in the first nine months of 2009, says Mr. Conrad. Debt is only 1.2 times annual cash flow despite a series of acquisitions.
All trusts face hard decisions with the 2011 tax. Zargon has set a 35 per cent payout ratio target, which would imply a payout cut. But in the third quarter, the ratio was just 52 per cent, based on $64 a barrel for oil and $3.43 per thousand cubic feet for gas. Both are much higher today.
“That means sharply higher cash flow ahead,” says the analyst. Surely, he adds, Zargon has noted Crescent’s successful conversion, which helped push the shares 60 per cent higher.
Only a mind reader can truly forecast post-conversion distributions, Mr. Conrad says. “But a market value just 75 per cent the value of its assets, efficient operations and its status as a genuine takeover target make Zargon Energy Trust a buy up to US$20.” It is $18.68 in New York, $19.60 in Toronto.
A gaudy yield
Brookfield Real Estate Services (TSX-BRE.UN; OTC-BREUF) also faces a dividend decision. It has a gaudy yield, too, at 11.3 per cent.
Although Brookfield is in real estate, it is not a REIT, which would have exempted it from the distribution tax. In fact, the trust gets its cash flow from the service fees and franchise royalties of residential property agents. Under the Royal LePage, La Capitale and Johnston & Daniel banners, it has 22 per cent of the residential market in Canada.
Mr. Conrad points out to his American readers that housing in Canada never suffered the same freefall that it did in America, “in large part because mortgage standards were never relaxed.”
Now it’s enjoying a rebound, he adds, thanks to low interest rates from the Bank of Canada.
Brookfield has a low payout ratio of 63 per cent and a balance sheet with very little debt. And it has a very wealthy parent. Brookfield Asset Management (TSX-BAM), one of Canada’s most powerful conglomerates (known as Brascan in a former life) “drops down” assets to the fund.
The parent firm has already arranged shareholder-friendly conversions at two other trusts, concludes the analyst. So buy Brookfield Real Estate Services up to US$12. It is at $11.39 in New York, $11.94 in Toronto.
A high dividend yield can mask many sins. But in a few select cases, it’s OK to give in to temptation and go for that big, fat yield.
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