Rethinking income trusts
The income trust market appears to be entering a plateau phase. The heyday of big capital gains appears to be over, although energy-based trusts could provide more upside if the price of oil continues to go crazy.
It’s been a great run. Over the past five years, the S&P/TSX Capped Income Trust Index has almost doubled in value. Investors who came to the party early have not only enjoyed great cash flow but in many cases are sitting on fat profits as well.
But it would be foolish to expect that pattern to continue. In fact, we can already see a slowdown in the frantic growth pace. To April 20, the Capped Income Trust Index is ahead only 6.8 per centin 2006, well behind the pace of the S&P/TSX Composite which shows a year-to-date gain of 9.2 per cent. If it weren’t for the strong performance of energy trusts (up 10.8 per cent to date) the overall sector would be even further behind the TSX pace. REITs have been especially weak, advancing only 2.6 per cent so far in 2006.
None of this should come as a surprise. The trust sector grew at an unsustainable pace during the first five years of this century, spurred by the high-th collapse which sent investment dollars scurrying to find new homes. That stage is over. Trusts have matured from fringe players to become full-fledged participants in the S&P/TSX Composite Index. The upstarts have become legit.
In the past couple of years, all the key provincial jurisdictions have passed legislation giving trust unitholders the same legal protection as corporate shareholders. Pension plans have finally shrugged off their initial reluctance and are becoming major players. Perhaps most important, the threat that the federal government would move to rein in the sector appears to be gone, probably forever. The Conservatives have said they have no intention of revisiting the issue, although the proof of the pudding will be in the upcoming budget. Assuming they don’t waver, the trusts appear to be home free. By the time a Liberal government is returned to power in Ottawa, income trusts will be so deeply entrenched in the fabric of our economic life that it would be tantamount to political suicide to attempt to dismantle them.
In short, trusts have come of age. The huge pools of cash that were sitting on the sidelines waiting for these events to unfold have largely been committed. That doesn’t mean there aren’t still profits to be made but going forward they are more likely to be driven by traditional forces such as interest rates, commodity prices, and general economic conditions. The days of simply buying any old trust and waiting for the price to shoot up are gone.
Investors should now base their purchase decisions on cash flow fundamentals, which is what trusts are supposed to be all about anyway. Yield, revenue stability, payout ratios, and business outlook will increasingly be the prime buy/sell motivators. This is as it should be. The whole raison d’etre of trusts is to provide above-average cash flow at reasonable risk. Anything else is gravy.
That is not to say there won’t continue to be capital gains potential. But it won’t come automatically; we are unlikely to see any more conservative blue-chip IPOs like Yellow Pages Income Fund rise as much as 70 per cent in value in little more than two years. Rather, investors seeking capital gains in the trust sector will have to do so in the same way as when buying stocks – by searching out undervalued situations and/or economic opportunities and assuming more risk.
The energy sector is a case in point. The soaring price of oil has produced huge windfall profits for people and it’s still going on. Share prices of some energy trusts like Canadian Oil Sands have doubled in just the past year. Of course, there could be more to come. But it’s no longer a sure thing. Buying into an energy trust today is a high-risk move. TD Bank predicted last week that the price of crude oil will drop 20 per cent later this year. Imagine what that would do to the share prices of energy trusts.
So at this point, my advice is to income trust investors is to lower their sights. If you are sitting on large capital gains, consider taking some of the money off the table. Make future purchase decisions on the basis of yield and cash flow sustainability. Avoid speculation.
In short, choose trusts on the basis of what they are supposed to be: income securities, nothing more, nothing less.