The Grave-Dressing of an Income Trust (Goodbye to Riocan)

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In this meaty, full-flavoured edition:

  • Feature: The Grave-Dressing of an Income Trust: Goodbye to Riocan
  • Trading notes: Superior Plus Income Fund (SPF.UN); Enervest Diversified Income Trust (EIT.UN)
  • Market Guy Mailbag
  • Market Guy’s Closing Bell: Air Canada

The Grave-Dressing of an Income TrustGoodbye to Riocan 
The remaining position in Riocan was eliminated at $18.69; and so marks the end of a beautiful relationship. I’d owned the units for 6 years and it was one of the most enjoyable investments of my lifetime. Sure, there were times when I doubted it.when I questioned its loyalty to the portfolio. But then it would go out and do something to make me fall in love with it all over again; a distribution increase here, an accretive acquisition there. In fact, I don’t think there’s an investment that consumed more space in this column than Riocan. I liked talking about it, thinking about it, and writing about it. I even enjoyed shopping at a local power centre, and looking up at the big sign that read, “Riocan owned and operated.” This never failed to make me smile. Here are some excerpts from previous columns:

From MG#3 in the summer of 2003:

“Market Gal is so used to me babbling on about the company, that she’s started pointing out many of the sites. It gives me a warm glow when she says, “That’s a Riocan property!” I just assumed she’d been doing the correct thing by ignoring me.”

And from a few months ago in MG#24:

“I have lost my ability to be rational about this company. Can you name a child Riocan? Is that possible?”

When I came home from work the other day and announced that I’d eliminated the position, she actually stopped watching Oprah, turned to me with a shocked look on her face and said, “Are you serious?” She was actually concerned and wanted to make sure that I was OK. I was pleased because anything that stops her from watching Oprah is a good thing.

To prove that I was fine, the other day we headed over to a Riocan-owned power centre in Ottawa. We had to pick up some things at Wal-Mart and grab a couple of Big Bacon Classics at Wendy’s. And do you know what? I was fine and experienced no pangs of guilt and no regrets. Given that I teach psychology, indulge me as I examine how this might be.

The Market Guy won’t be crying when he drives past this sign.  

Steve Duck is a psychologist who researches interpersonal relationships. He notes that when an important relationship comes to an end, each party comes up with a story as to what happened and why the pairing had to be dissolved. Through the generation and subsequent telling of our story, we try to preserve our reputation and come to terms with the loss. He called this process, “grave-dressing.” In a sense, I’ve been doing a little grave-dressing on the Riocan sale. Here’s my story:

  • The units trade at a decided premium to not only the other retail-focused REITs, but the entire Canadian REIT universe. Some of this premium is justified, given Riocan’s stellar track record, proven management, solid partnerships, long lease terms, high market cap, and diversified client base. However, at the time of sale, the yield was hovering just over 6.5%. That doesn’t afford much of a risk premium over bonds even though you’re undertaking equity risk.

  • The sale also illustrates what those in behavioural finance refer to as “risk aversion in the domain of gains.” In other words, we like to protect our profits. I’ve been invested since the beginning of the REIT-run, so I’m happy to take some profits, rebalance the portfolio and reduce my risk.
  • In early March, Riocan CEO Ed Sonshine exercised some options and then sold units at prices just over $19. Sure, there are many reasons for insider selling…but the top dog sure isn’t buying.
Thanks for the memories, Ed. You made $7 million in compensation last year. No wonder you’re smiling. The Market Guy is too.  

Sometimes when a relationships ends, we secretly hope that things don’t work out so well for the other person. Or at least you hope that things work out better for you. For example, if I ever go to a high school reunion, there’s a certain ex-girlfriend that would make me smile is she’d managed to gain 250 pounds and develop a bizarre facial tick. OK, so maybe I’m being petty and a little extreme. Let’s make that 175 pounds and a bunion problem. But unlike many of the relationships that end, I hope for the best for Riocan. I want it to be happy, successful, and to bring joy into the lives of others. In fact, there’s a part of me that believes, maybe, someday, our paths might cross again. Perhaps if the situation is a little different, maybe the flames will burn just as bright as they have over the past 6 years.

Trading notes
Superior Plus Income Fund (SPF.UN on the TSX) 
I’ve cut my exposure to SPF by one-half, after paring the position at $31.53. The units have subsequently retreated to less than $30 and I’ve noticed some analyst downgrades, for whatever that’s worth. Like so many other business trusts, this one has had a fantastic run over the past couple of years. With distributions pegged at $2.40, the current yield is over 8%. The yield on my original purchase price is just shy of 11%. I still like the trust, its diversified revenue stream, rising distributions and proven management. So why trim the holding? I’m sounding like a broken record, but I’m just taking some profits and reducing my risk level.

Enervest Diversified Income Trust (EIT.UN on the TSX)
Although I found Riocan to be bloated and Superior to be worth a paring, that doesn’t mean that I’m swerving away from the sector. In fact, as the trust market was reeling at the end of March, I initiated a modest position in Enervest Diversified Income Trust. This is a closed-end fund that invests in, wait for it, income trusts. The units were purchased at a price of $7.58. Based on an annual distribution of $0.84, this represents a yield of over 11%. According to a recent news release, it’s anticipated that 58% of the 2005 distributions will not be considered taxable income, so this one goes into a non-registered account. Here are some other quick hits on the fund:

  • With over 178 million units outstanding, liquidity is not a problem. I’ve seen a fair number of closed-end funds that don’t trade very much and sport fairly significant buy-ask spreads.  

  • The management fee, which was reduced in 2002, now stands at 1.5% on the first $250 million of net asset value and 1.0% after that. This compares quite favourably to others in the sector. For example, the Sentry Select Diversified Income Trust (SDT.UN on the TSX) comes with a management fee of 1.5% and no reduction at any level of net asset value. These fees certainly beat the majority of mutual funds available, so I can’t complain. 

  • Their portfolio is currently invested 20% in oil and gas royalty trusts, 17% in REITs, 16% in pipelines and utility trusts, with the remainder spread across resource, consumer, energy distribution and transportation trusts.

I know what some of you are thinking. Why not grab units of SCITI Trust (SIN.UN on the TSX), a closed-end fund that attempts to match the performance of the Scotia Capital Income Trust Index? With an MER of 0.42% and a yield of just over 9%, surely this makes sense. Not so fast, Chester . First, it has a much lower non-taxable component. Given that I’m going non-registered, taxation issues have to be considered. Second, the fund is float capitalization-weighted, so it leans heavily to the big trusts. For example, Canadian Oil Sands stands at almost 8% of the portfolio. Third, the Scotia fund is heavily biased to the energy sector. In fact, the fund is over 40% invested in oil and gas royalty trusts. I’m already well-represented in the patch. Pass.

Fair enough, but with the trust market behaving so erratically these days, why buy in? I continue to hold several individual names in the sector, so why grab a fund? Given the recent pullback and my paring of the higher-priced names, I wanted to put some money in play. I’m not saying it’s a buying opportunity, but I’m more curious than I was a few weeks ago. However, with the volatility, I’m not enthusiastic about placing bets on any sub-sector in particular. Plus, this is the busiest time of year for me at work. It’s made searching for value difficult. Meanwhile, Market Dad’s been confined to the house after having his gall bladder removed. On the negative side of things, he had his gall bladder removed. On the positive side, he’s had the time to obsess over the markets and make money by snapping up beaten-down trusts. While that’s been going on, I’ve begun marking 2000 pages of fourth-year research projects, grading oral presentations, and working on a special project for the dean’s office. The full-time job is impairing my trading activity. This is how resentments are born.

Who knows? Maybe the trusts will dip again in a few weeks when my schedule clears up. In any event, if I’m going to put some of my hard-earned money at risk, the diversified approach of a closed-end fund makes sense right now. I’ve only committed a modest number of funds to the purchase, so this is not a full commitment. Although the sector has bounced a bit, if a downward trend resumes, I’ll be more than happy to ante-up at lower prices. In other words, I’m dipping my toe in the water. It’s a little cool, but not too bad.

Markey Guy Mailbag
Here’s a sampling of what’s been coming through the inbox these days, each letter followed by my response:

Letter #1: New subscriber Ron K. writes

I have just discovered your wonderful site and have placed myself on your mailing list. I’m an old man who has been investing for years both in drips (bns, bmo and trp since the mid eighties) and income trusts. The vast majority of my income trusts are enrolled in their drip plans. Do you think that is a good stragety generally speaking. My rational is that as long as the distributions are maintained and I don’t sell I will be buying more shares at a lower cost base. In the past this has worked wonderfully for me regarding bmo and and bns. However banks never cut their dividends National Bank excepted. Looking forwared to your Newsletter.

MG: From an intellectual perspective, I like the idea of DRIPs for high yield equity names that generate predictable (and hopefully increasing) income streams. If it makes sense for quality common equities, it would seem to make sense for the quality trusts. Plus, you typically get these shares at a discount to market and I love buying quality on sale.

However, I have an even stronger preference for having the cash in my hand. I want to be able to use the cash how I see fit and I can’t always guarantee that I’ll want to use the dividends to buy more shares. In other words, I’m afraid of the DRIP commitment. For example, I currently have a position in TransCanada Corp (TRP on the TSX), but have no interest in adding shares either on the open market or via a DRIP. Rather, I’ll pool their dividend cash with that received from other names in order to initiate a new position or extend a favourite existing position. I find that with a DRIP I’m surrendering control over the cash.and that would feel wrong.

Keep in mind that your strategy has served you well for 20 years, so don’t let my idiosyncrasies hold any sway!

Letter #2: Loyal reader Dick from Edmonton checks in:

Congratulations, you have reached the zenith of Bill Simmons and Peter King — that’s right you were printed off at work and read in the bathroom.  Just thought you would enjoy this knowledge.

MG: Some would suggest these columns are best left in the bathroom. But thanks for making me laugh out loud.

Letter #3: Jack G. responds to MG#25, in which I indicated being uncomfortable about energy trusts yielding under 9%:

I have owned AET and PWI since their IPO’s in about 1996. Along with REF, REI ,ERF,YLO  and PEY, they have certainly been my best income performers…

I disagree with your 9% argument. I will agree with you if you are  talking about other low quality O/G trusts or almost all of the flakey business trusts. If you remember the early days, (circa- 1996), most of the O/G trusts came to market with a 15% yield or greater. However, after 8 to 10 years, the market now recognizes that, while they are still an equity, the good ones are not as risky as as first thought.

I still have to find and study your prior reports 1-24. I hope they are still available. Without seeing them, I will just ask if you have ever reported on PEY.UN.  I got into it very late but is now my largest holding. Unlike all of the other O/G trusts that grow reserves by buying mature properties and causing dilution. These guys live by the drill bit. They only pay out less than 50% of net income, and the rest goes into production development.

MG: With the names on your list, you’ve had one heck of a run. Beautiful. I agree that some of the advances in the royalty trust sector can be traced to growing respect in the market. As you mentioned, many of these names were yielding 15% quite recently and investors had just shy of zero enthusiasm. However, as I’m sure you’ll agree high energy prices and low interest rates have been the dominant factors at play here. Change either or both of these factors, and it’s back to no respect. What’s alarming to me is the speed at which changes in sentiment can occur. My becoming uncomfortable with yields under 9% is quite an arbitrary, almost emotional thing. Simply, this is the level at which my investing pendulum has shifted from greed to fear. This also gets back to the whole “risk aversion in the domain of gains” element that aided my sale of Riocan.

Your letter makes me think of the early days of the royalty trusts. Remember when Pengrowth and its 100% payout ratio, live by acquisition strategy was the standard-bearer? I had loaded up on the name to such an extent that it assumed a hefty overweight in my portfolio. All right, it was more than was obese. Now their model seems old-fashioned and out of step with the Peyto’s, Bonavista’s and Zargon’s (among others) of the world. Peyto and the early adopters of the low payout, live by the drill bit model have increased confidence in the sustainability of the sector and clearly altered expectations of how royalty trusts are supposed to function. And after reading the recent profile of Peyto CEO Don Gray in Report on Business Magazine, I concur with their front page assessment, “What’s not to like?” Plus, you have to love Peyto for the following:

  • it’s the lowest cost operator in the energy trust sector
  • it sports an outstanding reserve life
  • it exhibits a very low payout ratio
  • there’s the possibility of distribution increases later this year

It sounds as though you’ve included Peyto as part of a diversified exposure to the energy trust sector. For myself, consider the following: I’m a fair number of years away from retirement. Market Dad worked for 34 years and has adamantly maintained that if you can do it, early retirement is the way to go. I like the sounds of that, and so I need a little extra yield from my investments to help me along the path. Anyway, Peyto is yielding just over 5%. Compare that with Bonavista at just under 11% or ARC at just under 10%. All three are generally considered to be high quality names. After recently eliminating my position in ARC, I’ve held on to Bonavista and its extra 500 points of yield. I’m not willing to gamble on Peyto’s unit price being able to make up for that spread. Of course, maybe I should hedge my bets and own Peyto, ARC and Bonavista. If that Goldman strategist is correct with his prediction of $105 oil, then you might as well pick royalty trusts by throwing a dart at the stock page.

Yes, previous columns are available. Use the column archive link located at the top-right of the website or click here.

Thanks for the great letter, Jack. Fun stuff.

Market Guy’s Closing Bell
Strangest two events occurring during the same week (also evidence that the apocalypse is upon us):

  • Investors scrambling to unload the highest quality income trusts.
  • Investors scrambling to get in on Air Canada ‘s new debt and equity offering. The offering actually had to be increased to accomodate the demand.
  New investors will need air-sick bags. First, when their investment tanks; and second if they receive a complimentary CD from Air Canada shill Celine Dion.

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…so do your homework before making any investment decisions. He’s currently shopping for a new BBQ. It must have porcelain-coated cast iron grills. It’s going to be a tasty season over at