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Income 100: Summer 2007

A year ago we helped you target Canada's best income trusts in our second All-Canadian Trust Guide. We ranked the largest trusts in Canada and assigned each a letter grade depending upon how its financial numbers stacked up.

Despite the carnage in the trust sector as a result of new tax rules introduced in late 2006, our picks hit the bulls-eye. Our top-flight trusts - those rated either A or B - gained an average of 11.7% over the past year. That continues a streak of strong performance. Since we started ranking trusts in 2005, our top trusts have gained a total of 44.9%. (Our figures assume you bought the top trusts each year and rolled the profits into the new top trusts in the following year.)

How did we do in comparison to the market? That depends on which benchmark you choose, but we use the Barclays Advantaged S&P/TSX Income Trust Index Fund since it reflects a wide swath of the income trust market. Last year was a difficult one for trusts and the index fund dropped 5.8%. In comparison, our selections added 17.5 percentage points of value. If you go back two years, the Barclay's fund has gained 20.7%. In comparison, our picks added 24.2 percentage points of value.

We hope to keep up the good results but we've decided to revise our approach this year because of the federal government's new tax on trusts. The announcement last fall of the new tax sent the S&P/TSX Income Trust Index plummeting more than 20% even though the tax won't come into effect for more than three years. Trusts have since recovered much of their losses, but investors are bruised and wondering what will happen next. The new tax is likely to shrink the trust sector, which will leave many investors scrambling for good income-yielding investments.

To help you spot opportunities, we decided to add a selection of income-generating stocks to our list this year. Our goal is to rate Canada's largest trusts and stocks based on their ability to provide generous income to investors for a reasonable price. Although we've used some high-powered math to arrive at our ratings, the results can be understood by anyone who's read a report card. The best firms score an A and good ones land a B. Solid but unspectacular candidates slip through with a C. Those that miss the mark go home with a D or even an F.

We are definitely not saying that you can make a fortune by buying every A-rated trust or stock. The market just isn't that predictable. We expect to be off target from time to time. But we do think that A-rated firms deserve your attention because they appear to possess all the necessary ingredients for success. On the other hand, we recommend that you be extra cautious when investing in bottom-of-the-class firms. Perhaps some of these firms possess hidden virtues, but those virtues aren't apparent in their current numbers.

Our grades are based purely on the numbers. We didn't factor in our personal opinions about a sector or a firm. Instead, we scoured the Bloomberg database for detailed financial information. We restricted our ratings to Canada's largest firms by market capitalization. We then trimmed the initial list to remove candidates that have been around for less than a year, or lack the robust financial data we need for our detailed analysis, or don't pay a dividend or distribution. Finally, we doled out marks based on three criteria:

Yield: The more money a firm puts in your pocket, the better. For trusts, we gave high marks to those with the highest distribution yields. (Just remember that pocketing a distribution is not the same as collecting a dividend. For one thing, you may pay more personal taxes on distributions than on Canadian dividends. ) For stocks, we gave top marks to those with high dividend yields and robust dividend growth.

Reliability: We like to see a high yield, but we like it even more when we feel confident that the yield will continue to be paid. To ensure our top-rated trusts are operating with a cushion of safety, we awarded high marks to those that pay out less in distributions than they generate in cash flow. For stocks, we like those with a high ratio of earnings to dividends.

We award additional marks to firms with little debt because balance sheets riddled with debt are riskier than those of less leveraged businesses. We measured each firm's reliance on debt by comparing its ratio of total-debt-to-total-equity against its peers in the same industry.

Value: On the value front we want to be able to buy lots of assets for a low price. So, higher grades went to firms with moderate-to-low price-to-book-value ratios. For trusts, we awarded the highest marks to those trading at low prices in comparison to their cash flow. We measured this a couple of ways, because while we wanted low price-to-cash-flow ratios in an absolute sense, we also wanted a trust's price-to-cash-flow ratio to be low compared to other trusts in the same industry. For stocks, we examined earnings instead of cash flow and gave high marks to stocks with low price-to-earnings ratios.

Putting our marks together we arrived at final grades for each of our 50 trusts and 50 stocks. In total, only 10 earned an A, but 24 managed a solid B. We think both the A and B groups are worth your consideration and we suggest that you don't get too caught up in which firm got an A and which got a B.

You should feel free to aim even further afield in an effort to discover businesses with unique or intangible features that may not be reflected in the hard numbers. To help you, we've rated even more top trusts and income stocks online at moneysense.ca. There you'll find our grades for the top 100 trusts and the top 100 income stocks. So, take a look if you don't spot your favorites on our list.

Before trading on the basis of our grades, you should make sure that a firm's situation hasn't changed in an important way. Read press releases, regulatory filings, and recent news stories to get up to speed on developments. We recommend limiting any one pick to a small portion of your portfolio. The best way to use our grades is as a starting point for your own research. Like any screening strategy, the purpose of the Income 100 is to help you hit upon a few good ideas that you can then investigate in more detail.

Download the table of the top 100 Stocks (a .xls file)
Download the table of the top 100 Trusts (a .xls file)

From the Summer 2007 issue


Updated Tables: January 2, 2008

Income 100 Stocks
Income 100 Trusts

Update: Summer 2008

Income 100: Summer 2008




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