Question
“Can trusts go broke or dissipate or do they go on for years like General Electric ?”
Answer
Income Trusts are businesses just like any other vanilla corporation. And like any other business, they can go broke or dissipate, however this is rare occurrence. Income Trusts were created to avoid the double taxation system, wherein the same corporate income is taxed twice, once at the corporate and once at the shareholder’s level. Income Trusts do not pay taxes at the corporate level but instead taxes are levied on the unitholders income from the company. In order to attain this tax status, income trusts must pay out a majority of their cash flow in order to maintain their trust status.
Income Trusts are as safe as their underling business. In order to be able to pay their large distributions, (which are 9% on average) Income Trusts typically operate in mature and stable industries which deliver strong and consistent cash flows.
However, there are some disadvantages as well to the income trust model. Unlike a regular corporation, earnings are not reinvested into the business. For unitholders this translates into lower opportunities for future growth and ultimately capital gains, with most gains coming from distribution income.
In Canada the average Oil & Gas Income Trust sits on 11 years of reserves. If the average Oil & Gas Trust did not expand reserves they would have to dissolve in a decade. Hence the average Oil & Gas trust spends about 20% of cash flow on capex (Capital Expenditures) for exploration and development, allowing the trust to achieve modest growth in production over the long term. In contrast a company like CI Financial Income Trust (A well established asset management firm) has a very small capex (Capital Expenditures) requirement and can grow organically as assets under management grows with time.
Because distributions are the main attraction to trusts, distribution stability and safety should be an investor’s principal concern. Trusts which cut their distributions have their share often plunge. Hence commodity producing companies are usually considered the “riskiest” of all trusts as commodity price fluctuations can put them in a situation where they might cut their distributions. This is also reflected in the DBRS’s (Dominion Bond Rating Service) policy of always rating commodity trusts lower than their non-commodity peers.
In order to avoid being stuck in a situation where a trust cuts their distribution one should look at the distribution payout ratio. As a rule of thumbs one should not invest in a commodity based Income Trust with a payout greater than 75% and one should not invest in a business/real estate trust with a payout greater than 95%. One should also screen for businesses with a high profitability as indicated with an ROE (Return on Equity) greater than 15%. And since cash flow is king one should look for stability and predictability in the cash flow statement in recent years.
Ultimately, when investing in Income Trusts one should expect small capital gains of 0 to 2% yearly on top of the 9% distribution yield yearly as income is paid out instead of being aggressively reinvested in the business. For these reasons Income Trusts have historically been a great retirement vehicle by providing current income with growth potential. Unfortunately the Canadian Government’s decision to start taxing trusts in 2011 will ultimately result in many trusts converting to corporations in 2011. Since this news has already been priced in, this development poses no threat to investors and is instead an opportunity to pick up great businesses at fair prices.
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