In today’s mouthwatering feast:

• Market Guy Mailbag
  • Shoppers Drug Mart Optimum Program
• Feature: Here a Trust, There a Trust (Part One)

Market Guy Mailbag

Julie in Kanata wanted to mention a customer loyalty plan that she uses. It’s the Shoppers Drug Mart Optimum Program and it rewards you with points on almost every purchase made in the store. When points are redeemed, customers receive a discount on their purchases ranging from 20% to 100%. Unfortunately there is a maximum of $75 per redemption, but it usually takes a while to hit that target anyway. “We’ve used it to get free diapers and lots of stuff,” she told me.

Earlier this year saw the launch of the CIBC Shoppers Optimum Visa card that allows you to collect points on purchases at other stores. Plus, if you’re at Shoppers and use the Optimum Visa card along with your regular Optimum card, you’ll receive 50% more points than usual. Free stuff gets me drooling like Homer Simpson at an all-u-can-eat buffet. Thanks, Julie.

Feature: Here a Trust, There a Trust (Part One)

The year was 1996:

• Caroline in The City, Boston Common, and The Single Guy were among TV’s highest rated shows. Civilization has since recovered.

• The Yankees were just beginning their run as The Evil Empire, defeating the Braves 4-2 to take the World Series. Civilization has not since recovered.

• I began a new policy of avoiding movie previews. All the commercials for the biggest hit of the year, Independence Day, ruined the best parts of the movie.

• Dolly the sheep was cloned. They can clone mammals, but there is no Arby’s in Ottawa. How far have we really come?

• And I was still living in my parent’s basement. The following year saw an end to that.

But for me, the most important moment of 1996 was something entirely different. One morning, I came up from the basement and started to read an investment newsletter that had just arrived at the house. In amongst the various predictions and analyses was a modest blurb on income trusts. Nothing would ever be the same again.

It seems as though your interest in trusts has been piqued. I’ve received a substantial amount of mail on the subject, with common questions being:

• What exactly is an income trust?
• Is the trust market overvalued?
• What trusts do you own?
• Do you know of any good websites for researching trusts?

As always with The Market Guy, ask and ye shall receive. I’ve developed a three-part series to deal with these and many other trust-related questions. In part one I’ll provide an introduction to income trusts and some of the most important things to consider. Parts two and three will deal with the different types of trusts and how I’m spending my money. I’ll also talk about some of the events that are looming on the horizon that will affect the entire sector. For those of you interested in more information, I’ll make sure to offer a few suggestions on where to head.

Trusts as equities

I’d like to start with the most important point of the series: Income trusts are equities, not fixed income products. Expecting them to be as safe as GIC’s or government bonds just isn’t realistic. Like many other equity investments, income trusts trade on the Toronto Stock Exchange and have become very, very popular since the bursting (and partial re-inflation) of the tech bubble. There are well over 100 trusts from which to choose and the market capitalization has topped $60 billion. These trusts are involved in a variety of sectors including pipelines, utilities, infrastructure plays, real estate, long life resources, conventional oil and gas, and a host of other businesses. Generally these are very slow growing businesses that generate a steady stream of income for unitholders. Many of the trusts are small caps and therefore, there can be issues of liquidity when it comes to trading the units. Many times I’ve encountered a wide spread between the bid and ask, or not enough shares available for much of a trade. However, I’ve never encountered this problem with the larger, more liquid trusts.

Trusts do have a number of features that make them unique among equity investments. In order to appreciate these differences, we need to talk about cash and corporate structure. Although I don’t really enjoy talking about corporate structure, I sure do love talking about cash. In fact, a column on trusts is just as exciting for me as reading Penthouse Forum is to a teenaged guy.

To borrow from Economics 101, companies generate cash when they sell their products. Every company hopes to have more cash than it needs to cover expenses. That is, they want to be cash flow positive. Ah, but what to do with that extra cash? They might decide to buy back their own stock, finance a project, reduce debt, or fund acquisitions. Or they can get me all excited by distributing some of the cash to the stockholders, via a dividend. An income trust (more accurately referred to as an income fund, but I’ll stick with trust for now) focuses on the latter by distributing much of the excess cash flow to the unitholders. Some funds offer their payouts every quarter, but most do it monthly. Personally, I’m addicted to the monthly payouts. Each cash injection reminds me of Renton shooting up in Trainspotting…ah, the euphoria of a perfect day.

Taxation

Like all good things, the perfect day must come to an end and this day ends when you have to pay taxes on the distribution. You see, the trust doesn’t have to pay corporate taxes on the income that is distributed. Rather, the burden is shifted to the unitholders. However, this is done in a relatively tax-friendly way. Typically, each distribution consists of two components: a fully taxable portion and a tax deferred portion. The fully taxable part is usually declared as other income on your tax return. With the deferred portion, you don’t have to pay taxes until you sell the holding. Even better, the tax people regard these deferred portions as a return of capital, to be treated as capital gains. This is fine to me because capital gains are the most tax efficient way to make money…better than dividends, better than interest, and definitely better than employment income.

Not all yields are created equal

Remember the Market Guy mantra: give me the cash….ohm. Say it. Sing it, if you prefer. When it comes to the income trust market, cash is king. How much should I expect to receive in distributions from Trust A this year? Divide that number by the unit price and the result is the yield. Trusts with very stable distributions tend to have yields in the mid to high single digits, while the more volatile payouts can result in yields reaching the mid to high teens. Of course this changes with interest rates. As a general rule, a high yield should be regarded with skepticism. Either there are substantial risks associated with the company, the sector, or the payout is less than stable. Also, make sure to know the difference between trailing yield, current yield, and projected yield. The trailing yield is usually based on the previous 12 months of distributions. Current yield uses what the company should pay out this year (or per annum based on the current monthlies). Projected yield uses what the company is likely to pay out in some future time period (say next year). The differences are important, especially if the payout is a moving target.

Payout ratios

Many investors have a nasty habit of focusing only on yield. However, you don’t want the trust paying out more money than it is taking in or using debt to artificially pump up the distributions. Therefore, it’s important to look for the payout ratio. This is the percentage of cash available for distribution that is actually distributed. The rule of thumb is that if a trust is distributing more than 90% of the flow, this is very aggressive. With a number of highly publicized distribution cuts and even cancellations, the market seems to be paying more attention to this metric. Investors seem to be impressed with conservative payouts because these are more easily sustained over time. Besides, being conservative also helps to improve the balance sheet of the trust and reduce the volatility of the distributions (and by extension, the unit price). For me, the payout ratio is the single most important statistic in the trust universe.

Stability ratings

To assist in the process, Standard and Poor’s and the Dominion Bond Rating Service have both developed ratings of distribution stability. For example, S&P uses a 7-point scale, with SR-1 denoting high stability and SR-7 indicating low stability. These ratings are accessible through theGlobeinvestor.com Income Trust Centre. Just head to the section titledIncome Fund Ratings. I like browsing through the various reports because they help me learn more about each company. All of this information is free, although you have to register to gain access to the S&P ratings.

I’m very excited about the rest of the series because I’ll have a chance to mention some specific companies. Here’s a teaser: what do phone books, garbage, shopping malls, and pipes full of oil have in common?

The Market Guy is an Instructor with the Department of Psychology at Carleton University. He’s not a professional advisor. He’s just a guy who loves investing and talking about the markets. During the power outage he marked papers by candlelight. Seek your illumination atmail@marketguy.ca