No Issues with New Issues: Running with the Trust Zombies

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In this action-packed edition:

  • Feature: A consideration of income trust IPO’s
  • Trading notes: ARC Energy Trust (AET.UN); RBC O’Shaughnessy International Equity fund

remember when investing in income trusts was so much fun. There were only a limited number of names, so the sector was easy to follow. It was like remembering the names of Canadian sitcoms. Few people cared about income product, so you never felt like a victim of the herd mentality. Around the same time, a friend of mine had a financial advisor loading her up with biotech and semiconductor plays and he dismissed trusts as quickly as an invitation to a leprosy festival. Trusts were deemed to be a retail investor thing, not suitable for “real” investors who knew what they were doing. Meanwhile, all I had to do was stay invested, sit back and make money. It was a wonderfully intimate party and the gains were comfortably-paced. Unfortunately, the party has since been crashed by investors of virtually every stripe. And these party-crashers have an insatiable appetite. They want yield product and they want it bad. They’ll devour just about anything, even if it’s crap. Call them trust zombies. This has led to valuations becoming strained, especially among the larger trusts, making it harder to find true value.

  Next time a zombie is trying to eat your brain, ask if they’ll take an income trust instead  

But why wouldn’t investors run to the sector? Basically, the world has aligned itself perfectly for investing. In fact, every wish that a trust investor could possibly dream of has been granted in the last few months. Let’s review:

  • The threat of marked interest rate increases? Not really a problem.
  • Liability issues in Ontario? Removed by legislation.
  • Inclusion in the S&P/TSX index? On the way!
  • Just enough craziness in the world to keep energy prices high? Lunatics are plentiful!
  • Enough analyst coverage? Firms are falling over themselves to cover the sector, even to the point of poaching each other’s talent.
  • Institutional buying? Income trust mutual funds and closed-end funds are about as hot as season one of Miami Vice, just released on DVD…now that’s hot!
  • New names to get excited about? There’s plenty of new product coming and that makes it easier to generate meaningful comparisons between names.

It’s absolutely perfect…and therein lies the danger. Here’s the flipside:

  • The interest rate picture will change and when it does, it could get ugly. Look at what happened to the trust market last spring when even the whiff of an interest rate spike slapped unit prices silly. Serious pain.
  • How much will inclusion in the index really be worth? It could be argued that the effects of inclusion have already been priced into the market.
  • The words “raising target” and “multiple expansion” have been creeping into many analyst reports. In other words, they have no idea how to value these things.
  • All that new money coming into the sector is great for prices, but indicates that investors may be chasing performance. This almost never ends well.
  • New product is fantastic, although we may be getting to the bottom of the barrel. I feel the same way about reality TV, now that Pauly Shore is getting his own show on TBS.
  • There’s always the possibility that governments will do something to screw things up…a truism if there ever was one.

So where does this leave the portfolio? Although I’m still overweight the sector and have unnatural attachments to many of the names, I’ve been paring back more in the past 6 months than ever before. I’m finding it harder and harder to find new names that I like. So to calm my tormented soul, I’ve had to find other ways of making money here…and the initial public offering (IPO) market for trusts has provided me with an effective way to do so.

Bring on the fresh meat: The bad ol’ days 
When most people think of an IPO, they seem to think about the dot-com days of 1999 and 2000. Remember all the stories about small web portal companies going public, making sudden millionaires out of CEO’s and financial backers? Did I say millionaires? Mark Cuban took Broadcast.com public in one the most successful IPO’s in stock market history. He eventually sold his shares and allocated some of his billions to purchase the Dallas Mavericks of the NBA. At least he knew enough to stay away from the NHL.

Even more remarkable about all those technology IPO’s, was that virtually anyone involved hit the jackpot. Receptionists, secretaries, gophers, the guy who watered the office plants; it didn’t matter. And shareholders were rewarded, albeit on a much smaller scale, with meteoric share prices that defied rational explanation. Did these things really happen? It seems so long ago. At least we have some great stadium names to remember and wax poetic about a bygone era. Let’s hope they never take away CMGI Field or 3-Com Park. Oh, they already have? Someone fetch me a tissue.

My reluctance to invest in technology stocks kept me from enjoying the party. While I did engage in some modest speculative trading (all right, I’ll come clean and call it day trading), I never maintained any significant tech positions and never participated in the tech IPO market. This owed much to 1) my lack of understanding of all tech investments. This ignorance continues to this day. I have no idea how to value these companies; plus, I prefer companies that have competitive advantages and pay dividends; and 2) my negative perception of IPO’s generally. When I thought of IPO’s, I couldn’t help but think of greasy, unscrupulous stock peddlers working out of poorly-ventilated basement offices with 25 other hacks using random phone number generators, each one desperately searching for the investing equivalent of the Glengarry leads. All right, so I have a vivid imagination. But you know what I mean.

  Come to think of it, maybeBoiler Room (2000) nails the image. Plus, you get a pre-Gigli Ben Affleck trying to copy Alec Baldwin’s memorable performance from Glengarry Glen Ross(1992). You can guess how that worked out.  

Fast forward to the trust IPO’s 
Since those crazy days, the IPO market has been rather anaemic, to say the least. There have been a few significant and highly-successful entries (e.g., Shopper’s Drug Mart, ING, etc), but it’s been new income trusts that have saved the investment dealers from eating dog food. It took two factors occurring simultaneously for me to become interested in IPO investing. First, the new product had to be coming from a sector that I knew well. New trusts satisfy this requirement quite nicely. Second, my participation had to be self-directed. In other words, I had to be able to resrearch the offering on my own and reach my own conclusions. No salespeople. Well, the discount brokerages seem to have taken care of this one.

Each of the major discount brokerages offers different services when it comes to new issues. A new issue describes any security that is being made available for the first time. This can involve common stocks, preferred shares, debentures, fixed income product, etc. However, it’s not only about IPO’s. Rather, new issues also include secondary offerings (e.g., a company with shares already trading on the exchange decides to raise capital by selling more shares to the public). When you find something that you’re interested in, you have to contact the broker to place an expression of interest. This means indicating the number of shares/units that you’d like to purchase. If it’s a hot deal, then you have to move quickly. The allocations procedure apparently observes a first-come, first-serve schedule. If you receive an allocation, there can be a wait of several days to weeks until the shares are sent to your account. Some deals take longer to complete than others, although they do offer a preliminary time frame when you place the expression.

There is considerable diversity in how the brokerages disseminate information about new issues and how they subsequently process expressions of interest. Some list all available new issues on their website, some are willing to email clients whenever new product becomes available, and some are willing to process orders online. The following table illustrates the differences:

 

New issue info
posted to web

Email notification
Placing expression of interest
BMO
No
No
Phone
CIBC
Yes
No
Phone
RBC
Yes
No
Phone
SCOTIA
No
Yes
Phone
TD
Yes
Yes
Phone, Web

TD Waterhouse is ahead of the others and has been for some time. However, Scotia McLeod Direct recently added email notification. When asked if they planned on extending more of their services online, a customer service representative seemed optimistic. Meanwhile, BMO Investor Line and RBC Action Direct indicated that no changes to their current procedures were expected. There’s nothing wrong with having to call your broker to see what’s available and place expressions of interest during the call…but I find it less convenient and far less enjoyable. And shouldn’t making money be enjoyable? Am I right, people?

My first attempts with trust IPO’s came in the summer of 2003, with the debut of Yellow Pages (YLO.UN on the TSX), and Enbridge Income Fund (ENF.UN on the TSX). Yellow Pages remains in the portfolio, while Enbridge was eliminated a while back. After that, I dabbled and subsequently dumped several other names including Atlantic Power and a few days ago, Keystone North America. The foray into Keystone (KNA.UN on the TSX) was supposed to be part of an IPO-double play with Spinrite (SNF.UN), Canada’s dominant yarn manufacturer. I actually wanted a substantial allocation to Spinrite, but it was sold out and I had to make due.

Zombies buying cemeteries…why not? 
Keystone claims to be the fifth-largest provider of funeral services in the United States, with 177 funeral homes and 9 cemeteries. I was able to get an allocation, but only 1/3 of the number of units that I wanted. Demand was very strong. Imagine that! Zombies pushing up the shares of a funeral company. Anyway, this suggested a pop on opening day.and that’s exactly what happened. I owned the units for about an hour and then sold them for a gain of roughly 13%. I had no intention of maintaining the holding and regarded this as nothing more than a candidate for flipping. I was not alone, as Andrew Willis reported in his Globe and Mail column, the day’s action came “To the delight of stock flippers everywhere.” If I can get the equivalent of 15 months worth of distributions for one hour of ownership, I’m making the trade.

However, I did actually look at the business and decided it was not something that I wanted to have in the portfolio. A flip is one thing, an investment is another. Here’s the central issue: I want my business trusts to be dominant in their sector. I want them to have some pricing power. Being the fifth-largest service provider in a highly-fragmented and competitive US market does not meet these criteria.

So what makes for a good flip? Well, a decent yield that is well-above average for the sector is a nice place to start. It also helps if the trust operates in a sector that is attracting plenty of investor interest. New issue business trusts are sizzling hot right now and Keystone has a demographic angle that never fails to leave some investors frothing at the mouth. Even though the baby boomers are a while from needing funerals, it always seems that someone is pumping these types of services as excellent long-term demographic plays. But to be honest, I’m not all that excited about investing based on demography. The problem with demographic plays is that everyone knows about them. When everyone knows about something, this shared knowledge changes the very character of that something. Business people are well aware of the population trends and if demand for a service is anticipated to be strong, then the market reacts accordingly. This means new businesses come into the field, driving up competition, lowering pricing power, and increasing investor risk. Look at the car companies. The baby boomers helped the automakers sell more cars than ever before. This could have been predicted by demography…but it sure wouldn’t have helped you to make money.

OK, so there are issues with new issues
When making an IPO play, you have to decide if it’s to be a flip or an investment. The only way to do that is to study the metrics of the deal and read the prospectus. Typically, the prospectus is available on the broker’s website or at www.sedar.com. Typically these things are a snooze, but they still manage to be infinitely more entertaining than Jay Leno.

  If given the choice between reading a 200-plus page prospectus for a funeral company or watching one hour of Leno, you know what The Market Guy will be doing. Shouldn’t the move from Carson to Leno be considered one of the biggest downgrades of all time?  

Studying the prospectus makes sense, until you consider one fairly significant problem: often you have to place an expression of interest before the final prospectus is issued. That means the details around yield and size of the offering may be subject to change and that can lead to some nasty surprises. When a deal is especially hot, there’s nothing to stop the parties involved from lowering the projected yield. For example, Keystone was originally marketed with a yield of 10.5%, but with strong demand, this was pushed down to 10%. That’s 50 basis points, which is a considerable move. The change was made after I’d already committed to the purchase. It all worked out, but this does illustrate one of the risks that I’m taking. I’d gone over the preliminary prospectus, so I was making as informed a decision as possible…even if the document was full of missing details.

In terms of secondary issues, the shares are usually made available at a price below market. This provides an incentive for participation and can help to get the deal done. However, I always keep in mind the risk that comes along with the time delay between placing the expression of interest and actually receiving the shares. If the stock runs into trouble in the interim, I can’t sell what I don’t yet own…and the commitment to purchase the shares, even if it means buying at an above-market price, is still firm. In any event, I’ve been able to extend a number of holdings, including Calloway REIT, Bonavista Energy Trust, and Inter Pipeline Fund via the secondary route.

Overall, I’ve found investing in trust IPO’s to be a useful way of squeezing a few extra bucks out of the sector. I know that it’s short-term trading behaviour and not investing. That’s why I only devote a small portion of investment cash to these types of activities. So far, it’s working. However, it’s conceivable that as this market continues to roar, the opening yields on trust IPO’s will continue to head south. As that happens, the potential for flipping decreases. In other words, any future expressions of interest may have to be for investment-worthy trusts. Then I’ll have to jump in with the rest of the zombies.

Trading notes
ARC Energy Trust (AET.UN)
I have eliminated my largest energy position, ARC Energy Trust at just under $20. The subject of an earlier paring at lower prices (see MG#23), it continued moving up along with just about every other energy name. I still love this trust. It has a relatively conservative payout ratio, proven management, low debt, decent reserve life, and a large market capitalization. In addition, when trusts are formally added to the S&P index, this one seems to be a logical candidate for inclusion. Simply, it’s top-notch and has the history and metrics that warrant trading at a premium valuation. In 2004, the trust returned almost 34% to investors (including distributions). And it was headed in the same direction to start 2005. But when I start seeing sub-9% trading yields on commodity-based trusts, I get nervous. I don’t care how low interest rates are or how many index players are going to be buying in. I don’t care about the strength in oil prices. At this point, it’s all about risk management and knowing when I need to leave the party. So it’s time to book some profits, consider myself one of the luckiest guys on the planet, and move on.

Keep in mind that I’m not eliminating my entire exposure to the energy sector. As I’ve said before, it’s a part of my blood now and I could never turn my back on it…no matter what it does. You have to stick with the ones you love, right? With positions in Bonavista, Acclaim, Real Resources, and several indirect holdings, I’m still well-represented in the patch. However, I’m now feeling more comfortable about my exposure and have addressed the three forms of risk identified in MG #23.

Dealing with the energy sector reminds me of Steve Irwin, the Crocodile Hunter guy on Animal Planet. He’s the guy who roams Australia in search of things that might kill him. Well, one time he found this impressive looking but very poisonous spider. So what does he do? Naturally, he gets down on all fours and puts his face about 4 inches away from the thing. Then he turns to the camera, and starts telling us more about the spider, its habitat, and behaviours. While he’s looking at the camera, the spider assumes an attack posture, which is the sort of thing that should provoke a serious Darwinian-skedaddle. Instead, Irwin grabs a stick and decides to start poking at the spider. Poke. Poke. Poke. Now the spider is really pissed, so of course Irwin looks away and starts talking to the camera again. I’m not sure what he said, but is was something like, “we’ve really got her angry now.” I’ve seen him do the same thing with snakes, crocodiles, and lizards and he does it every episode. Well, the energy sector is just like that spider. Appreciate it but don’t push your luck!

  Don’t make any strange movements when approaching the energy sector.  

RBC O’Shaughnessy International Equity
I have also added a new mutual fund position to the portfolio. Let’s welcome the RBC O’Shaughnessy International Equity fund. This fund started up in January and helps to diversify my portfolio a little away from the Great White North, where most of my investing dollars are allocated. I’ve been a holder of the Canadian and US value editions of this series since their 1997 debut and have been pleased with the performance, fee structure, and other metrics that I believe are important (see MG#22 for my take on selecting mutual funds). In fact, the O’Shaughnessy approach will take centre stage in a future column.

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. Who cares about the NHL? Pitchers and catchers are now reporting and will be available for all your steroidal needs. Get a different kind of juice over at mail@marketguy.ca