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Income trusts
IPO craze may raise quality questions

Income trusts are the hottest type of investment on the street. The National Post recently reported that 90 per cent of initial public offerings on the Toronto Stock Exchange (TSX) were for income trusts. They pay generous cash distributions; offer some growth potential; and sometimes provide a nice tax benefit. What's not to like? I agree income trusts have a long future ahead of them on Canadian markets, but be careful not to get lured into junk.

IPO: a contrarian view

Effectively, a public offering of shares occurs when a company sells its shares to the public at a set price. The term "public offering" refers to the fact that the shares are offered (i.e. sold) on a public stock exchange, such as the TSX.

An initial public offering (IPO) is the same thing, but it represents the very first time such shares are being offered to the public; hence the word "initial". In other words, a company whose shares are making their trading debut on, for instance, the TSX has made an IPO.

Investors ultimately try to "buy low, and sell high". If you're buying shares from an IPO, you're part of the "buy" side of a company's "sell" transaction (i.e. the IPO). Company insiders, who help determine the timing and price of an IPO, presumably know a lot about the company because, well, they're insiders - i.e. they have information about the company that the investing public probably does not know.

In general that doesn't sound like a winning proposition for the buyer over time since the timing and price of the buy occur as a result of company insiders' desire to sell. An IPO isn't always a bad investment; but it stands to reason that IPOs are not great investments, as a group.

Income trusts' raison d'etre

An income trust is simply one type of legal structure within which a business may "reside". Most organizations with shares trading on a stock exchange are set up as corporations. An income trust, as the name implies, is a trust - just like a mutual fund or exchange-traded fund. For trading purposes, however, income trusts are just like stocks.

It's safe to say that the main motivation for companies organizing as (or spinning off assets into) a trust is to put as much after-tax cash flow into investors' pockets as possible. Corporations can and do pay dividends, but the corporation must first pay tax on its profits before being able to pay them out as dividends to shareholders. Then, individual shareholders pay tax on a portion of the dividends received.

Income trusts, by design, are structured around more mature businesses with relatively more consistent cash flow but less potential for future growth. This is the case in general, but there are exceptions. For tax purposes, trusts are taxed just like individuals but with an important basic distinction.

Trusts are taxed on all income at Canada's highest marginal tax rate (46.4 per cent in Ontario). However, trusts can avoid tax if they flow out a sufficient amount of income out to its unitholders (i.e. shareholders).

Some businesses, like real estate and energy firms, benefit from special tax deductions. But rather than simply deducting it from income within a corporation, a trust can actually flow this tax benefit out to unitholders. The result is that a portion of the cash distributed to unitholders is tax-deferred.

Businesses which intend to pay out as much as possible to its owners will be able to do so most tax efficiently via a trust structure.

The last income trust cycle

The last time income trusts were the hottest thing going (around 1996), they were marketed much more aggressively. At that time, investors were given the opportunity to pay for their income trust units in instalments. For instance, if a unit was offered for $10; the investor could pay $5 now, and the other $5 in a year's time. Problem was, by the time the second half was due, many trusts had halved in value.

This more recent boom in income trusts is nothing like 1996. The general stock market this time around is very weak; whereas 1996 was a pretty positive environment for stocks. Bay Street also learned from the instalment receipt craze of 1996; offering no such options this time around.

With accounting irregularities and corporate fraud, investors feel safer with investments paying out cold hard cash. Also, ultra-low interest rates make income trusts naturally attractive to those depending on their investments for income.

Don't equate the market's infatuation with income trust with the tech euphoria that ruled the day just three years ago. However, there is one disturbing trend underway in this sector. Corporations are converting to income trusts just to see its share price rise. This makes no sense and is ludicrous according to Bill Shaw, lead manager of the Mavrix Dividend & Income fund.

In a recent conversation, Mr. Shaw reminded me what happened the last time this sector was overheated. He said the sector contained roughly forty trusts. When income trusts busted, eight disappeared. That's a "mortality" rate of 20 per cent. - a significant amount.

With the proliferation of income trusts to flood the market over the past year, there definitely is a quality issue in general. Many existing trusts are quality investments. However, many are not and are not likely to survive the next time this sector goes through a cleansing.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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